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Meditari Accountancy Research

Are auditors law-abiding citizens?


G. Geva
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To cite this document:
G. Geva, (2004),"Are auditors law-abiding citizens?", Meditari Accountancy Research, Vol. 12 Iss 2 pp. 41 - 65
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Are auditors law-abiding citizens?
G Geva
School of Accountancy
University of Witwatersrand

Abstract
The auditing and accounting profession must provide appropriate disclo-
sure of the going concern status of an entity, especially when that status is
threatened. Auditors have an obligation to consider the wider legal envi-
ronment of an entity, including all relevant case law, when they perform
any such audit. Despite this obligation, the auditing profession appears to
violate important legal principles. The auditor’s approach to the going
concern status of an entity is contained in the South African Auditing
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Standard, SAAS 570 ‘Going Concern’. The South African legal frame-
work’s approach to this issue emerges from the Supreme Court case
Philotex (Pty) Ltd v Snyman. This article explores the fundamental dis-
agreement between the auditor’s approach to the going concern problem
and that adopted in terms of the wider South African legal framework.
Key words
Going concern problem
South African Auditing Standard SAAS 570 ‘Going Concern’
South African legal framework
Audit stance
Legal stance
Audit and legal paradigms clash

I am indebted to Professor Mike Larkin and Professor Harvey Wainer, both of the
University of Witwatersrand, for their ongoing and selfless assistance with this article.

1 Introduction
This article explores the dissonance between the legal and audit worlds due to
incongruent responses by these worlds to the ‘going concern problem’. The
going concern problem arises when the ability of a company to continue oper-
ations into the future is uncertain.
In order to examine this topic, the article reviews one of the South African
Auditing Standards (SAASs), which in effect constitute the ‘rulebook’ that

Meditari Accountancy Research Vol. 12 No. 2 2004 : 41–65 41


Are auditors law-abiding citizens?

guides the auditor1 in conducting his work. The auditing standard reviewed
dictates the way in which an auditor should word the audit opinion in a situation
where the company in question may no longer be a viable going concern. As a
result of this particular South African Auditing Standard, entitled SAAS 570
‘Going Concern’, published by the South African Institute of Chartered Ac-
countants (SAICA 2000), there appears to be an irreconcilable dissonance
between the legal and auditing responses to the going concern problem.
In order to explore this dissonance, several areas have been researched and
these are discussed in separate sections in this article. First, it is essential to
understand the legal stance on the going concern problem. Second, it is neces-
sary to establish the obligations of the auditor to this legal stance – is the auditor
a messenger of the law? Once this question has been answered, a review of the
audit stance on the going concern problem is given. Only once both approaches
have been clarified is it possible to consider whether or not the audit and legal
paradigms clash. It is useful to begin with an evaluation of the legal stance on
the going concern problem.

2 The legal stance


The legal paradigm that is relevant to the going concern problem is dealt with in
section 424(1) of the Companies Act, Act 61 of 1973 (South Africa 1973) and
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the related leading case Philotex (Pty) Ltd v Snyman 1998 (2) SA 138 (SCA).
Section 424(1) of the Companies Act, Act 61 of 1973 states:
When it appears . . . that any business of the company was or is being carried on
recklessly or with the intent to defraud creditors of the company or creditors of any
other person or for any fraudulent purpose, the Court may . . . declare that any per-
son who was knowingly a party to the carrying on of the business in the manner
aforesaid, shall be personally responsible, without any limitation of liability, for all
or any of the debts or other liabilities of the company as the Court may direct. (South
Africa 1973)
Section 424(1), which deals with reckless trading, is directly linked to the going
concern problem. When the going concern status of an entity is in doubt, the
ability of the entity to honour its obligations to its creditors is uncertain. If the
entity’s ability to discharge its debts is uncertain, then directors who continue to
trade and incur debts may be regarded as trading recklessly. If the directors
continue to trade and incur debts when there is no reasonable chance that the
creditors will receive payment, then, in general, it is reasonable to infer that the
company is conducting its trade with ‘the intent to defraud creditors’ as noted in
R v. Wax 1957(4) SA 399 (C), Dorklerk Investments (Pty) Ltd v. Bhyat 1980(1)
SA 443 (W) and S v. Harper 1981(2) SA 638 (D). ‘Intent to defraud creditors’
addresses even a scenario where there is only a single instance of the company’s
________________________

1 This auditor is a theoretical character that represents the role model of the profession.
Where ‘he’ is used, ‘she’ is also intended.

42 Meditari Accountancy Research Vol. 12 No. 2 2004 : 41–65


Geva

incurring a debt that it knows it will be unable to pay, as noted in Gordon and
Rennie v Standard Merchant Bank Ltd 1984 (2) 519 (C).
A director who knowingly conducts the business of the entity in a ‘reckless’
manner is guilty of an offence in terms of section 424(3). Should there be
evidence of gross negligence on the part of the director, then this is adequate to
convict the director, as indicated in S v. Goertz 1980(1) SA 269 (C) at 272, and
in Fisheries Development Corporation of SA Ltd v. Jorgensen 1980(4) SA 156
(W) at 170.
Since fraud is regarded as both a delict and a crime, a director who violates
section 424(1) may be held liable in his/her personal capacity to the creditor
who has been defrauded, as noted in Orkin Brothers Ltd v. Bell 1921 TPD 92,
Ruto Flour Mills (Pty) Ltd v. Adelson 1959(4) SA 120 (T), Alex Murray (Pty)
Ltd v. Perry 1961(2) SA 154(N) and Milne NO v. Harilal 1961(1) SA 799 (D).
It is important to note that section 424(1) targets the directors of a company
who trade recklessly, and not the auditor of such a company. This is so because,
as was stated in Powertech Industries Ltd v Mayberry 1996 (2) SA 742 (W) at
750 H, 749 F and 746 G, an auditor ‘while carrying out his statutory functions,
is not carrying on the company's business’ – a prerequisite for possible liability
under section 424(1). The directors of an entity are involved in the ‘carrying on
of a company's business’, while the auditor merely reports on the company’s
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financial statements.
The Philotex case contains a judgement of the Supreme Court of Appeal and
applies the principle contained in section 424(1). In the Philotex case, the
company in question suffered great financial and business difficulty during the
years 1984 to 1989. During those years, the company was technically insolvent.
Technical/factual insolvency refers to the situation when the financial state-
ments of a company indicate that the total liabilities or debts of the entity exceed
the value of all the assets of the company. Theoretically, if the company were to
sell all its assets (both long-term and short-term assets), it would still have
insufficient cash to discharge all its debts. It is important to realise that directors
who continue to trade and incur further debts in the face of technical insolvency
are not necessarily considered to be trading recklessly, as noted in Ex parte de
Villiers & Another NNO: In re Carbon Developments (Proprietary) Limited (in
liquidation) 1993(1) SA 493(AD). Technical insolvency is thus a warning light
to the directors and creditors that a material uncertainty may exist as to the
ability of the company to continue as a going concern. It is not, however, an
automatic indication that section 424(1) has been violated.
In addition to being technically insolvent, the entity in the Philotex case was
also commercially insolvent. Commercial insolvency is not a theoretical, eso-
teric concept – it is a reality. It occurs when a company is literally unable to pay
its creditors in the day-to-day running of the business. This may occur even if
the total assets of the entity exceed the total liabilities and the entity achieves
technical solvency. Commercial insolvency is a more reliable indicator of a
going concern problem than technical insolvency.

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Are auditors law-abiding citizens?

Directors who continue to trade and incur further debts in the face of com-
mercial insolvency are far more likely to violate the provisions of section
424(1). Directors who order goods or services make an implicit representation
to the related creditor that the entity will be able to honour its debts as they
become payable. When the directors know that there is no possibility that such
debts will be honoured, they are defrauding the creditor. The same applies if the
directors are careless to the point of recklessness in their consideration of
whether the entity will be able to discharge such debts, as noted in Orkin Broth-
ers Ltd v. Bell 1921 TPD 92, Rex v. Myers 1948(1) SA 375 (A), Ruto Flour
Mills (Pty) Ltd v. Adelson 1959(4) SA 120 (T) and Ex parte de Villiers &
Another NNO: In re Carbon Developments (Proprietary) Limited (in liqui-
dation) 1993(1) SA 493(AD).
Despite both technical and commercial insolvency, the directors of the entity
in the Philotex case continued to trade and to incur debts. During this time the
entity relied on its holding company for financial support in order to meet the
payments that it could not meet itself. Eventually, however, the holding com-
pany ceased to support the entity and the entity was liquidated. The question
before the Supreme Court of Appeal was the following: did the directors of the
entity ‘trade recklessly’? Were the directors of the entity in violation of sec-
tion 424(1)?
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The specific details of the case are beyond the scope of this article. What is
relevant are the principles contained in the case, which for ease of reference
have been named:
(i) The Reasonable Director principle.
(ii) The Material Uncertainty principle.
The court quoted, with approval, the case of Ozinsky NO v Lloyd 1992 (3) SA
396 (C) at 414G, in which the Reasonable Director principle was originally
stated, as follows:
If a company continues to carry on business and to incur debts when, in the opinion
of reasonable businessmen, standing in the shoes of the directors, there would be no
reasonable prospect of the creditors receiving payment when due, it will in general
be a proper inference that the business is being carried on recklessly. [Emphases
added.]
In other words, the Reasonable Director principle gives a character sketch of the
‘reasonable businessman’, which the court uses as a medium of comparison.
The directors in question must be compared to the reasonable businessman2.
This reasonable businessman has all the attributes of the directors in question.
He has at least the same level of knowledge, expertise, business sense and
acumen as the directors. Yet the reasonable businessman must have one addi-
tional attribute – objectivity. The reasonable businessman assesses the situation
of the entity without bias, his vision is not blurred by personal motives to
________________________

2 As with ‘the auditor’, this is a generic term and includes businesswomen.

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Geva

maintain his employment or the existence of the company. He must objectively


decide whether the entity can continue into the future as a going concern.
This leads to the second principle laid down by the court – the Material Un-
certainty principle. It states that when there is uncertainty regarding the ability
of an entity to pay its creditors and hence a material uncertainty regarding the
ability of the entity to continue as a going concern, the directors of the entity
may be regarded as either negligent or reckless. Whether the directors are
regarded as negligent or reckless depends on the individual circumstances of
each case.
The Material Uncertainty principle is set out in the following two statements
made by the court in the Philotex case. The first statement below indicates when
a director is regarded as negligent. The second indicates when a director is
regarded as reckless, which the courts have held is equivalent to gross negli-
gence. The court in Philotex (146G-I) states the following regarding a negligent
director:
Participation in business necessarily involvestaking entrepreneurial risks but s 424
only penalises the subjection of third parties to risk where (apart from the case of
fraudulent trading) it is grossly unreasonable. If, therefore, in a given case there is
some ground for thinking that creditors will be paid but a reasonable businessman
would nonetheless, because of circumstances creating a material but not high risk of
non-payment, refrain from running that risk, the director who does run that risk by
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incurring credit, and thus falls short of the standard of conduct of the reasonable
businessman, trades unreasonably and therefore negligently vis-à-vis creditors. [Em-
phasis added.]
In the Philotex case, the court (146I – 147C) then states the following regarding
a reckless director, as opposed to the negligent director discussed immediately
above:
That departure from the reasonable standard could not fairly be described as gross,
however, and the director concerned would not be hit by the section. By contrast, an
instancethat manifestly would fall foul of the section is where the reasonable busi-
nessman would realise that in all the circumstances payment would not be made
when due. To incurcredit in that situation would, as a matter of degree, be so plainly
more serious a departure from the required standard than the conduct in the first
example that one has no difficulty categorising it as grossly unreasonable and there-
fore grossly negligent. This second example, one must emphasise, is an extreme one
and it would, in my view, impose an unduly heavy burden on a plaintiff in s 424 pro-
ceedings to require proof of circumstances in which a reasonable businessman would
assess non-payment as a virtual certainty. So, if a plaintiff were to present evidence
warranting the conclusion that when credit was incurred there was, objectively re-
garded, a very strong chance, falling short of a virtual certainty, that creditors would
not be paid, that case would, I think, also involve the mischief which the section was
intended to combat. It is not possible to attempt to draw the line between negligence
and recklessness more exactly. Each case must turn on its own facts and involve a
value judgment on those facts. [Emphasis added.]
The Material Uncertainty principle has two consequences – firstly it teaches that
section 424 only applies when a director is considered reckless. It is clear from
the above excerpts that whether or not section 424 applies to a director depends

Meditari Accountancy Research Vol. 12 No. 2 2004 : 41–65 45


Are auditors law-abiding citizens?

on the extent of the uncertainty. That is the extent of the uncertainty regarding
the ability of an entity to pay its creditors and to continue as a going concern.
Here the court indicates the importance of the concept of degrees of uncertainty.
There is a spectrum of uncertainty.
The court highlights two important demarcations on the spectrum, namely (i)
material but not high uncertainty, and (ii) material and high uncertainty. These
two demarcations are crucial in the court’s decision as to whether a director is
considered reckless or not.
If there is only a ‘material but not high risk of non-payment’, the director is
not considered reckless. If there is material but not high uncertainty, the director
is merely negligent and section 424 does not apply. The director is only reckless
if there is a ‘material’ and ‘very strong chance, falling short of a virtual cer-
tainty’ that the entity will not pay its creditors and hence not continue as a going
concern. When there is material and high uncertainty, the director is reckless
and section 424 applies.
For the purposes of this article, the second consequence of the Material Un-
certainty principle is even more pertinent. The second consequence is this: as
soon as there is a material risk that a creditor will not be paid, the court states
that a reasonable businessman would not continue to trade.
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If the reasonable businessman would not continue to trade, it follows that the
entity is no longer considered a going concern in the eyes of the court. This
holds true both when there is a material but not high uncertainty and when there
is a material and high uncertainty. All that is required by the court is that there
be a material uncertainty. Once the uncertainty is material, the reasonable
businessman is expected to stop trading; the entity is no longer a going concern
in the opinion of the court.
This is evidenced in the court’s assertion (146G-I) that if ‘there is some
ground for thinking that creditors will be paid but a reasonable businessman
would nonetheless, because of circumstances creating a material but not high
risk of non-payment, refrain from running that risk, the director who does run
that risk by incurring credit, and thus falls short of the standard of conduct of the
reasonable businessman, trades unreasonably and therefore negligently vis-à-vis
creditors.’ [Emphasis added.]
Thus, even when there is only a ‘material but not high risk of non-payment’,
the court concludes that a reasonable businessman would not trade, and the
court does not consider the entity to be a going concern. Even when the director
is only considered negligent and section 424 does not apply to the director, the
court no longer considers the entity to be a going concern. All that is required
for the entity to lose its going concern status is that there be a ‘material but not
high risk’ that the creditor will not be paid. It thus follows logically that when
there is ‘a very strong chance, falling short of a virtual certainty, that creditors
would not be paid’ the court will also consider the entity not to be a going
concern.

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Geva

In summary, once there is a material risk regarding the non-payment of credi-


tors, the court requires that a Reasonable Director stop trading. Once there is
material uncertainty regarding the ability to pay creditors, the court no longer
considers the entity to be a going concern.
It is helpful to contrast the audit stance on the matter with the legal principles
that have been elucidated. But before such an analysis can be performed, it is
vital to understand the duty that the auditor owes to the legal paradigm, if any.

3 The auditor is a messenger of the law


The accounting and auditing profession is not unaware of the influence of
financial statements and of auditors’ reports on the public. In fact, the objective
of financial statements is emphatically repeated in accounting standards and
auditing textbooks throughout the world. According to AC 000, the ‘Framework
for the preparation and presentation of financial statements’, paragraph 12,
issued by the South African Institute of Chartered Accountants (SAICA 1990),
the objective of financial statements is ‘to provide information about the finan-
cial position, performance and changes in financial position of an enterprise that
is useful to a wide range of users in making economic decisions’.
Furthermore, the rulebook of the auditor, the South African Auditing Stan-
dards, states in paragraph 9 of SAAS 700, ‘The auditor’s report on financial
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statements’ (SAICA 2001), that ‘the responsibility of the auditor is to express an


opinion on the financial statements based on the audit’. The purpose of financial
statements is to provide useful information relating to the financial performance
and financial position of the entity concerned. The purpose of the audit report is
to express an opinion on whether the financial statements fairly present the
financial position and performance of the entity.
One of the most vital pieces of information that the financial statements and
auditor’s report can offer is whether or not the entity is a going concern. If the
financial statements present the entity as a going concern and the auditor does
not qualify his audit opinion, users of the financial statements can justly infer
that the entity is in fact a going concern.
According to sections 286(1), 286(2), 300(a) and 300(i) of the Companies Act
(South Africa 1973), every company, whether public or private, is under a legal
obligation to:
(i) Prepare annual financial statements.
(ii) To have those financial statements audited.
The former obligation is to be discharged by the directors of the company, while
the latter is to be performed by the auditor. The appointment of an auditor, the
role of the auditor and the auditor’s rights and responsibilities are all embodied
in the Companies Act. The auditor exists by virtue of statute. In section 300 (i)
the Act states that the auditor’s obligation is:
to satisfy himself that the annual financial statements or group annual financial
statements fairly present the financial position of the company or of the company and

Meditari Accountancy Research Vol. 12 No. 2 2004 : 41–65 47


Are auditors law-abiding citizens?

its subsidiaries and the results of its operations and those of its subsidiaries . . . [Em-
phasis added]
In addition, the Public Accountants’ and Auditors’ Act, Act 80 of 1991, section
20(1)(f) contains the following guidance on the nature of the report issued by
the auditor:
No person acting in the capacity of auditor to an undertaking shall, without such
qualification as may be appropriate in the circumstances . . . express an opinion to
the effect that any financial statement . . . presents fairly . . . the affairs of the under-
taking and the results of its operations . . . unless he is satisfied, as far as is reason-
ably practicable having regard to the nature of the undertaking in question and of the
audit carried out by him, as to the fairness or the truth or the correctness, as the case
may be, of such financial statement. (South Africa 1991) [Emphases added]
In summary: the auditor may not legally issue an unqualified report (commonly
known as a ‘clean’ report) unless he is satisfied that the financial statements do
indeed fairly present the financial position and performance of the entity in all
material aspects.
One of the most pervasive and basic factors that the auditor has to consider is
whether or not the entity is a ‘going concern’. The ‘going concern’ concept
revolves around the question of whether the entity will continue in operational
existence for at least one year into the future from the audit report date. Most
frequently, as in the Philotex case, it is liquidity and cash flow problems of an
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entity that threaten its going concern status. The ‘going concern’ concept has
been defined in various texts. One of the most informative definitions is the
following explanation of the ‘going concern assumption’ from the draft state-
ment on the ‘Presentation of Financial Statements’, paragraph 30, issued in
March 1995 by the International Accounting Standards Committee (IASC):
An enterprise should prepare its financial statements using the going concern as-
sumption unless management intends, or has reason to believe, that the enterprise
has the need to liquidate or curtail materially the scale of its operations in the fore-
seeable future. In such cases, an enterprise should prepare its financial statements
using the liquidation or break-up basis of accounting. (IASC 1995)
A similar explanation of the ‘going concern assumption’ is presented in the
South African Accounting Standards in AC 000, ‘Framework for the preparation
and presentation of financial statements’ (SAICA 1990), and was adopted
without significant adjustment by SAAS 570, ‘Going Concern’ (SAICA 2000)
itself.
The assumption that the entity is a going concern is one of the most crucial
assumptions that have to be met prior to the preparation of the financial state-
ments. If it is not met, the fundamental method of preparing the financial state-
ments is drastically altered. The nature and measurement of the underlying
assets and liabilities of the entity is reassessed – the assets are now valued at the
estimated proceeds to be obtained in the event of a forced sale or liquidation
sale. The net worth of an entity measured on the premise that the sale of its assets
will occur in a forced or liquidation sale represents a much lower figure. A
liquidation scenario may also require the recognition of liabilities not recognised

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Geva

in a going concern scenario – for example, retrenchment and liquidation cost


provisions. In short, the net worth of a company in the event of liquidation is
much lower than in the case of the entity's being a going concern, ceteris pari-
bus.
To assess whether the financial statements ‘fairly present’ the financial posi-
tion and performance of an entity, it is vital for the auditor, as a point of depar-
ture, to assess whether the going concern basis of measurement is appropriate.
The assessment of the going concern status of the entity is vital if the auditor is
to issue an opinion on the fairness of the financial statements as is required of
him by law.
After appropriate audit procedures have been performed, the Companies Act,
Act 61 of 1973, then requires the auditor to communicate his opinion of the
fairness of the financial statements to the shareholders (members) of the com-
pany. This obligation arises in section 301 (1) of the Act, which states that the
auditor:
shall make a report to the members of the company to the effect that he has examined
the annual financial statements and group annual financial statements and that in his
opinion they fairly present the financial position of the company and its subsidiaries
and the results of its operations and that of its subsidiaries in the manner required by
this Act. (South Africa 1973).
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It is clear that the duty of the auditor to inspect the financial statements arises
out of statute. Furthermore, the duty of the auditor to report to the members
(shareholders) of the company also arises out of statute. It follows that in per-
forming these duties; the auditor must inspect and report on the financial state-
ments using principles sourced from the legal paradigm. The auditor is a human
extension of the statute. The auditor is a tool employed by the law to give effect
to its intention. If the auditor were to perform that function without complying
with the principles of the legal system, he would be a poor messenger of the
law.

4 The audit stance


The audit stance on the going concern issue is expressed in South African
Auditing Standard 570 ‘Going Concern’ (SAICA 2000). Statements of South
African Auditing Standards are of crucial importance to the auditor. While they
do not have the force of statute, they are issued by the Public Accountants’ and
Auditors’ Board, which is a statutory body. Compliance is therefore considered
mandatory in the profession. The statements themselves are peremptory and the
preface contained in each South African Auditing Standard states the following:
Statements of generally accepted auditing standards referred to as South African
Auditing Standards (SAASs) are to be applied in the audit of financial statements.
[Emphasis added]
Further, the preface of each Standard contains the following declaration of
authority:

Meditari Accountancy Research Vol. 12 No. 2 2004 : 41–65 49


Are auditors law-abiding citizens?

‘This auditing standard is issued on behalf of the Public Accountants’ and Auditors’
Board and is accordingly binding on all Registered Accountants and Auditors.’ [Em-
phasis added]
In performing an audit, these standards act as a rulebook to the auditor. It is
recognised by the profession that in a court of law, when deciding whether or
not the auditor has performed his auditing duties adequately, the court is likely
to compare the conduct of the auditor to that prescribed by the South African
Auditing Standards (SAASs). Before we review the audit stance on the going
concern matter, it is necessary to highlight the two types of audit opinions that
the auditor may express on a set of financial statements. The audit opinions are:
(1) An unqualified opinion.
(2) A qualified opinion.
An unqualified opinion is colloquially referred to as a ‘clean report’ from the
auditor. The auditor states that, in his opinion, the financial statements fairly
present the financial position and performance of the entity. The financial state-
ments meet the approval of the auditor and he deems them to be a fair portrayal
of the financial position and results of the entity.
By contrast, a qualified opinion from an auditor sounds a warning bell to the
user of the financial statements. A qualified opinion indicates that the user of the
financial statements should exercise caution when analysing them. The qualified
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opinion contains three different types of opinion:


(i) An ‘adverse’ opinion.
(ii) A ‘disclaimer of opinion’.
(iii) An ‘except for’ opinion.
In an ‘adverse opinion’, the auditor indicates that he disagrees with the financial
statements as prepared by the directors and as a result believes that, as a whole,
the financial statements do not fairly present the financial position of the entity.
In a ‘disclaimer of opinion’, the auditor does not express any opinion at all on
the fairness of the financial statements. A ‘disclaimer of opinion’ is given when
the auditor has inadequate evidence to either agree or disagree with the informa-
tion given in the financial statements. Finally, in an ‘except for’ opinion, the
auditor indicates that he agrees with the financial statements as a whole, except
for a specific, isolated element. In respect of this isolated element, the auditor
cannot form an opinion due to uncertainty, or, alternatively, considers the
element incorrect.
According to paragraph 38 of SAAS 700, ‘The auditor’s report on financial
statements’ (SAICA 2001), an ‘except for’ opinion is appropriate when the
element of the financial statements with which the auditor disagrees (or on
which the auditor cannot form an opinion) is not considered ‘material and
pervasive and/or fundamental’ to the financial statements as a whole. As a
result, the auditor does not disagree with the financial statements as a whole, but
only with the isolated aspect. Hence, the auditor expresses the opinion that the
financial statements as a whole do fairly present the financial position of the

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entity, ‘except for’ that specific element in respect of which the auditor qualifies
the audit opinion.
In summary, an unqualified opinion represents a ‘clean’ opinion, while a
qualified opinion expresses cause for concern – either because the auditor
disagrees or because the auditor has uncertainty regarding a material issue.
Many prospective lenders and creditors of an entity may rely substantially on
the nature of the opinion given by the auditor. Furthermore, the shareholders
(members) and prospective shareholders of an entity consider the audit opinion
when they decide whether to maintain or acquire an investment in the entity. An
unqualified opinion is far more comforting than the alarm signal sent out by a
qualified opinion.
Given this background, let us examine the interface between three elements:
SAAS 570, the going concern problem and the auditor’s opinion on the financial
statements. It is in this interface that one can detect a dissonance between the
legal and the audit paradigms.
The instruction given by SAAS 570 is now reviewed. SAAS 570 prescribes
how the auditor should act when there may be a material uncertainty as to the
ability of the entity to continue as a going concern. The standard prescribes to
the auditor:
(i) What audit procedures to perform in such an event.
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(ii) That he should form a conclusion as to whether a material uncertainty


exists.
(iii) What type of audit opinion to give when a material uncertainty does in
fact exist.
However, in advising the auditor on what audit opinion to give, we will see that
the auditing standard contradicts the legal stance outlined earlier. Ironically, the
rulebook of the auditor contradicts the legal paradigm from which the auditor’s
duty stems.
In respect of the audit procedures that the auditor should perform to investi-
gate the going concern status of the entity, paragraph 24 of SAAS 570, ‘Going
Concern’ (SAICA 2000), stipulates:
When events or conditions have been identified which may cast significant doubt on
the entity’s ability to continue as a going concern, the auditor should:
(a) review management’s plans for future action based on its going concern as-
sessment,
(b) gather sufficient appropriate audit evidence to confirm or dispel whether or
not a material uncertainty exists through carrying out procedures considered
necessary, including considering the effect of any plans of management and
other mitigating factors, and
(c) seek written representation from management regarding its plans for future
action. [Emphasis added]
The above excerpt is published in bold type in SAAS 570, ‘Going Concern’. This
is significant, since the content published in bold type in any SAAS statement is

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Are auditors law-abiding citizens?

prescriptive and must be adhered to by the auditor. Any content that does not
appear in bold type is not prescriptive and the auditor is under no professional
obligation to comply with this – it is merely explanatory. Every SAAS statement
is prefaced by the following explanation:
Statements of SAASs contain the basic principles and essential procedures (identified
in bold type black lettering) together with related guidance in the form of explana-
tory and other material. The basic principles and essential procedures are to be in-
terpreted in the context of the explanatory and other material, which provides guid-
ance for their application.
Once the above investigative procedures have been performed, the standard then
demands that the auditor form a conclusion as to whether a material uncertainty
exists regarding the entity’s going concern status. This is again indicated in bold
type in SAAS 570 paragraph 28:
Based on the audit evidence obtained, the auditor should determine if, in the audi-
tor’s judgement, a material uncertainty exists related to events or conditions that
alone or in aggregate, may cast significant doubt on the entity’s ability to continue as
a going concern. [Emphasis added]
Once the auditor has formed a conclusion regarding the existence of a material
uncertainty, the auditor is instructed by SAAS 570 regarding what type of audit
opinion to give. It is this instruction that creates the unacceptable dissonance
with the legal paradigm. In paragraphs 30 and 31, SAAS 570 states that when a
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‘material uncertainty exists’ the auditor ‘should express an unqualified opinion’


(SAICA 2000) (emphasis added). The instruction to issue an unqualified audit
opinion in the face of material uncertainty is given in bold type and is thus
prescriptive.
For a full understanding of the dissonance, the instruction of SAAS 570 re-
garding the audit opinion required must be explored further. Paragraphs 30 and
31 must be analysed in their entirety. Paragraph 30 states:
If the use of the going concern assumption is appropriate but a material uncertainty
exists, the auditor considers whether the financial statements:
Adequately describe the principal events or conditions that give rise to the sig-
nificant doubt about the entity’s ability to continue in operation and manage-
ment’s plans to deal with these events or conditions.
State clearly that there is a material uncertainty related to events or conditions
which may cast significant doubt about the entity’s ability to continue as going
concern and, therefore, that it may be unable to realise its assets and discharge
its liabilities in the normal course of business. [Emphasis added]
Paragraph 31 then states:
If adequate disclosure is made in the financial statements, the auditor should express
an unqualified opinion . . . [Emphasis added]
The issue of ‘adequate disclosure’, mentioned immediately above, is addressed
later in this article. First, it is necessary to identify the flawed logic contained in
SAAS 570, more specifically in the following extract of paragraph 30 of SAAS
570:

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If the use of the going concern assumption is appropriate but a material uncertainty
exists . . .
To expose the flawed logic of SAAS 570, let us explore the concept of uncer-
tainty as it relates to the ability of an entity to continue as a going concern. As
discussed earlier, there is a spectrum of uncertainty. At one extreme, there is
absolute certainty that the entity will continue as a going concern, while, at the
other end, there is absolute certainty that the entity will cease to exist. These two
extremes are very rarely, if at all, encountered in commercial practice. However,
on this spectrum, degrees of uncertainty are encountered. Four types of such
uncertainty are explored here, as these are pertinent to the argument at hand.
The four types are:
(i) Simple uncertainty.
(ii) Immaterial uncertainty.
(iii) Material but not high uncertainty.
(iv) Material and high uncertainty.
Only the uncertainties mentioned in (iii) and (iv) were directly addressed in the
Philotex case. Hence it is only when these two types of uncertainty are present
that the dissonance between the audit and legal worlds exists. However, for
completeness, all four types of uncertainty are explored below.
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‘Simple uncertainty’ is defined here as a situation where the auditor simply


cannot conclude whether the entity is a going concern or not. After applying all
the investigative procedures required by SAAS 570, the auditor is unable to
formulate an opinion. In such a situation, the auditor would not sign off on the
financial statements, but would rather issue a ‘disclaimer of opinion’ to indicate
such simple uncertainty.
‘Immaterial uncertainty’ exists when there is a slight degree of uncertainty
regarding the ability of the entity to continue as a going concern. The degree of
the uncertainty is such that there is an immaterial chance that the entity will
become insolvent. All entities in practice are exposed to immaterial uncertainty
at the very least. No entity is immune to the threat of liquidation. However, in a
healthy company, the threat of liquidation is immaterial and it is thus probable
that the entity will continue to trade in the foreseeable future.
In such a situation, the court in the Philotex case would rule that there is no
material uncertainty. Hence the reasonable businessman would be justified in
continuing to trade in these circumstances. The director would not be regarded
as either negligent or reckless. The court states that in the absence of material
uncertainty, the entity is fairly considered a going concern.
‘Material but not high uncertainty’ has already been discussed earlier, when
exploring the legal stance on the going concern problem. The concept is ex-
pressed in the Philotex judgement at 146H-I and is repeated here:
If, therefore, in a given case there is some ground for thinking that creditors will be
paid but a reasonable businessman would nonetheless, because of circumstances
creating a material but not high risk of non-payment, refrain from running that risk,

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Are auditors law-abiding citizens?

the director who does run that risk by incurring credit, and thus falls short of the
standard of conduct of the reasonable businessman, trades unreasonably and there-
fore negligently vis-à-vis creditors. [Emphasis added]
If a ‘material but not high risk of non-payment’ of creditors exists, the Supreme
Court of Appeal requires that the reasonable businessman cease trading. The
directors of the entity should not expose the creditors to any further financial
risk. It follows that, when there is a ‘material but not high’ uncertainty about the
ability to pay creditors, the reasonable businessman should cease to trade. In a
situation of ‘material but not high’ uncertainty, the court considers the entity not
to be a going concern.
‘Material and high uncertainty’ is equivalent to a second scenario addressed
in the Philotex case. This has also been discussed earlier. The Philotex case at
147B – 147C states:
So, if a plaintiff were to present evidence warranting the conclusion that when credit
was incurred there was, objectively regarded, a very strong chance, falling short of a
virtual certainty, that creditors would not be paid, that case would, I think, also in-
volve the mischief which the section was intended to combat. [Emphasis added]
If there is a ‘very strong chance, falling short of a virtual certainty’ that creditors
will not be paid, the Supreme Court of Appeal again expects the reasonable
businessman to cease trade. The businessman who continues to trade is consid-
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ered reckless by the court. In a scenario of ‘material and high uncertainty’, the
court once again considers the entity not to be a going concern.
What now becomes apparent is the flawed logic contained in SAAS 570. This
flawed logic is contained in the revisited words of paragraph 30 of SAAS 570:
If the use of the going concern assumption is appropriate but a material uncertainty
exists . . .
It is illogical to assert that the going concern assumption is appropriate when a
material uncertainty exists. The Supreme Court of Appeal clearly indicates that
when there is material uncertainty regarding the ability of the entity to continue,
the entity should not be considered a going concern. The reasonable business-
man should cease trading. The court states that a businessman who continues to
trade in the face of material uncertainty is negligent at best and reckless at
worst. To assert, as SAAS 570 does, that the going concern assumption is
appropriate despite the presence of a material uncertainty is incorrect. It goes
against the principles set out in the legal paradigm – a paradigm to which the
auditor owes his existence.
Proponents of SAAS 570 may attempt to defend this auditing standard. They
could suggest three possible arguments based on the text of the standard itself.
The arguments in favour of SAAS 570 are the following:
(i) The auditor must ensure that there is adequate disclosure in the financial
statements of the material uncertainty that threatens the going concern
status.
(ii) SAAS 570 does not preclude an auditor from qualifying the audit report.

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(iii) SAAS 570 encourages the auditor to give a qualified audit opinion if, in
the auditor’s judgement, the entity will not be able to continue as a going
concern.
Each of these arguments is now addressed. The basis of the first argument is
located in the bold print section of paragraph 31 of SAAS 570 that states:
If adequate disclosure is made in the financial statements, the auditor should express
an unqualified opinion but modify the auditor’s report by adding an emphasis of mat-
ter paragraph that highlights the existence of a material uncertainty relating to the
event or condition that may cast significant doubt upon the entity’s ability to continue
as a going concern and draws the attention to the note in the financial statements
that discloses the matter set out in para .30. [Emphasis added]
The fact that the auditor adds an ‘emphasis of matter paragraph’ does not alter
the nature of the opinion given – the auditor still issues an unqualified opinion.
The emphasis of matter paragraph simply refers the user to a note in the finan-
cial statements where the directors discuss the material uncertainty.
The emphasis of matter paragraph in no way disagrees with the directors’
financial statements. On the contrary, it emphasises a particular aspect of those
statements. It emphasises the note that describes those factors that cast doubt on
the going concern status of the entity. The ‘emphasis of matter’ paragraph does
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not detract from the message given by the unqualified opinion – the financial
statements fairly present the financial position and performance of the entity.
An unqualified audit opinion asserts that the auditor considers the financial
statements to fairly present the financial position of the entity. How can the
auditor make such an assertion if there is material uncertainty? In the case of
material uncertainty, the Supreme Court of Appeal considers that the company
is not a going concern. The auditor, by contrast, agrees with a set of financial
statements that present the entity as a going concern. Emphasising disclosure
regarding the nature of the material uncertainty is simply inadequate to over-
come this dissonance.
The user of financial statements must not only be informed in words of the
existence and nature of the material uncertainty. This is the very least of the
disclosures that should be required by the SAAS statement. The user must, more
importantly, be informed of the financial effect that this material uncertainty has
on the entity. The user must be informed in numbers. What is required is a
numerical representation of the assets and liabilities of the entity on the liquida-
tion basis.
Where there is material uncertainty, it is not appropriate to present the finan-
cial statements of the entity as those of a going concern. The entity is not a
going concern in the eyes of the law. No amount of disclosure regarding the
circumstances that create the material uncertainty will ever compensate for the
absence of the most crucial disclosure – the financial position of the entity on
the liquidation basis.

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Are auditors law-abiding citizens?

SAAS 570 emphasises the importance of adequate disclosure regarding the


material uncertainty. SAAS 570 (SAICA 2000) states in bold type in paragraph
32 that:
If adequate disclosure is not made in the financial statements, the auditor should ex-
press a qualified or adverse opinion, as appropriate.
SAAS 570 prescribes that the auditor must issue a qualified opinion when
inadequate disclosure of the material uncertainty is made. Yet the auditor must
give an unqualified, clean opinion, despite the fact that the entity is erroneously
presented as a going concern. The irony inherent in the instruction of SAAS 570
is blatant.
The second argument of the proponents of the standard might be that SAAS
570 does not preclude the auditor from qualifying the audit report. They would
argue that this notion is contained in the second section of paragraph 31 of
SAAS 570. This part of paragraph 31 is not in bold type, and it states:
In extreme cases, such as situations involving multiple material uncertainties that are
significant to the financial statements, the auditor may consider it appropriate to ex-
press a disclaimer of opinion instead of adding an emphasis of matter paragraph.
[Emphases added]
It may appear that SAAS 570 indicates that the auditor should give a qualified
opinion if material uncertainty exists (a disclaimer of opinion is considered to be
a qualified opinion). But one must examine the SAAS more closely. Firstly, this
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part of paragraph 31 refers to ‘extreme cases’ – only in extreme cases is the


qualification appropriate. Secondly, it requires that there be numerous material
uncertainties – ‘multiple material uncertainties’ – before the auditor considers a
qualification.
Thirdly, this part of paragraph 31 uses the words ‘the auditor may consider it
appropriate to express a disclaimer of opinion’ [emphasis added] – the modal
verb ‘may’ indicates that the auditor is under no obligation to qualify the report.
On the contrary, the auditor has the option as to whether to qualify the report or
whether to simply add an ‘emphasis of matter paragraph’.
Finally, the excerpt of paragraph 31 quoted immediately above is not in bold
print – in other words, it is not prescriptive. This is in contrast to the first part of
paragraph 31, which appears in three quotations above, which is in bold type
and is prescriptive. Thus paragraph 31 of SAAS 570 (SAICA 2000) states the
following in unbold, non-prescriptive type:
In extreme cases, such as situations involving multiple material uncertainties that are
significant to the financial statements, the auditor may consider it appropriate to ex-
press a disclaimer of opinion instead of adding an emphasis of matter paragraph.
[Emphases added]
The same paragraph states the following, in bold, prescriptive type:
If adequate disclosure is made in the financial statements, the auditor should express
an unqualified opinion . . . [Emphasis added]
The message of the SAAS statement is clear: even if a material uncertainty
exists, the auditor should issue an unqualified opinion. In extreme cases involv-
ing multiple material uncertainties, the auditor may qualify the report, but may

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also leave the audit opinion unqualified. The Supreme Court of Appeal does not
require ‘extreme cases’. It does not require ‘multiple material uncertainties’. The
Supreme Court of Appeal requires only a ‘material but not high risk’ that the
creditors will not be paid (Philotex at 146G-I). It is evident that the legal para-
digm and the audit paradigm disagree.
Finally, the proponents of the standard may argue that SAAS 570 (SAICA
2000) does support the auditor to qualify his opinion when an entity is not able
to continue as a going concern. This is contained in the bold prescriptive type of
paragraph 33 (SAICA 2000), which states:
If, in the auditor’s judgment, the entity will not be able to continue as a going con-
cern the auditor should express an adverse opinion if the financial statements have
been prepared on a going concern basis.
Here SAAS 570 (SAICA 2000) encourages the auditor to qualify when he
considers the entity not to be a going concern. On this point SAAS 570 and the
Supreme Court of Appeal agree. Both the court and SAAS 570 state that when it
is relatively certain that the entity will not continue, the entity should not be
considered a going concern. Both the court and SAAS 570 would encourage the
auditor to qualify the audit report if the entity were presented as a going con-
cern.
The problem with the advice of SAAS 570 is that it encourages the auditor to
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qualify the report only at an advanced stage. The threshold set by SAAS 570 is
excessively high – only when the auditor is relatively certain that the entity will
not continue as a going concern should he qualify the report. The threshold set
by the Supreme Court of Appeal is lower and more conservative. The court does
not require the reasonable businessman to be certain that the entity will not
continue. The court states that as soon as there is material uncertainty regarding
the ability of the entity to continue, the entity is no longer a going concern. It is
at this earlier point that the court would require the auditor to qualify the report.
SAAS 570’s opinion of the point at which the entity ceases to be a going con-
cern differs from the opinion of the Supreme Court of Appeal. If the auditor acts
according to his rulebook, SAAS 570, he will disobey the legal paradigm in
which he operates.
To fully appreciate the anomaly of SAAS 570 and its support of an unquali-
fied opinion, it is useful to cite instances where the auditor is required to qualify
the audit opinion. These are set out in SAAS 700, ‘The auditor’s report on
financial statements’ (SAICA 2001). From Appendix II of SAAS 700, it is
evident that the auditor is encouraged to qualify his report in response to far less
serious issues. If the entity does not make a provision for doubtful (unrecover-
able) debts owing to it, the auditor should qualify the audit report. If the short-
term liabilities of the entity are shown as long-term liabilities, the auditor should
also qualify the audit report.
There are other instances where the auditor qualifies the report in the face of
an uncertainty that is far less serious than the uncertainty regarding going
concern. In these instances, the auditor issues either an ‘except for’ qualification

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Are auditors law-abiding citizens?

or a ‘disclaimer of opinion’ qualification, depending on the nature and extent of


the uncertainty. Appendix II of SAAS 700 states that when the auditor is uncer-
tain about the value of a single asset, such as trading stock, the auditor is re-
quired to qualify the audit report. If the entity does not perform a physical count
of its inventory, the auditor must qualify the audit report. If the entity performs
an inventory count but the auditor is unable to attend the count, the auditor must
qualify the audit report.
Yet when the value of every single asset is uncertain – the auditor does not
need to qualify. When the very basis of the preparation of the financial state-
ments is in question, when the going concern assumption itself is uncertain,
suddenly the auditor is encouraged to issue an unqualified report, a clean report.
The auditor readily qualifies in response to far less serious matters, so why is
qualification discouraged here? Why, when it is most needed, is qualification
avoided? There appears to be little justification for the unqualified opinion that
SAAS 570 recommends.

5 The audit and legal paradigms clash


It is evident from the foregoing discussion that the audit and legal paradigms
disagree. Based on the principles established by the Supreme Court of Appeal in
the Philotex case, if there is material uncertainty about an entity’s ability to
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continue as a going concern, the reasonable director should cease to trade. The
court does not consider the entity to be a going concern. If the directors continue
to trade in such circumstances, they are regarded as negligent and may well be
considered reckless. If the court applies section 424(1), such directors will be
liable for all the debts of the company.
The audit world has a very different response to the same circumstances. In
an identical situation – when there is material uncertainty regarding the entity’s
going concern status – the auditor is encouraged to issue an unqualified opinion.
Where the directors would be considered negligent by the court, the auditor may
issue a clean report. Even where the directors may be considered reckless, the
auditor may issue an unqualified report. At a time when the court considers the
entity not to be a going concern, the auditor wrongfully allows it to be presented
as such.
The auditor has a very powerful and loud warning bell at his disposal, namely
the qualified audit opinion. He should utilise this warning bell. How is it possi-
ble to have a clean audit report when, under the law, the directors of an entity
are trading negligently and possibly even recklessly? How can an auditor
condone the misrepresentation of an entity as a going concern? Why does the
auditor not align himself with the legal system that gave birth to him?

6 In defence of SAAS 570


In addition to those discussed above, several other arguments have been put
forward in defence of SAAS 570 by the academic and professional audit worlds.
These arguments are examined and addressed below.

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One of the most pertinent factors that should be considered in defence of


SAAS 570 is a timing issue. SAAS 570 was submitted for approval to the
International Federation of Accountants (IFAC) in November 1997, while the
verdict of the Philotex case was only finalised in November 1998. The judge-
ment of the Philotex case was not available at the time when SAAS 570 was
drafted. One cannot expect the standard to resonate with case law that was not
even in existence at the time. The apologists for SAAS 570 also claim that it is
also not feasible to expect the body of SAAS statements to be altered each time
a relevant piece of case law emerges.
These points do help us to understand the reasons for the contradictions be-
tween the auditing and legal paradigms; however, they do not constitute an
adequate defence for SAAS 570. It cannot be argued that it is impractical to
alter the auditing standards to keep in line with the legal paradigm. The rate of
change of significant aspects of the legal paradigm is not relentless. Significant
developments in the legal world are not excessively frequent. As such, it is not
unreasonable to expect the audit world to keep pace with such developments.
There is currently an irreconcilable dissonance between the legal and audit
paradigms that must be addressed. It is not a matter of practicality – it is a
matter of principle. To align the auditing and legal paradigms is a necessity that
should not be ignored due to inconvenience. The revision of SAAS 570, albeit a
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significant exercise, is a small price to pay to remove the dissonance that cur-
rently exists between the audit and legal worlds.
The second defence is now reviewed. This defence argues that the SAAS
statements themselves state that it is part of the auditor’s duty to comply with
the legal framework in which he operates. It therefore follows that the auditor,
in complying with SAAS 570, should also comply with the spirit of section 424
of the Companies Act and the principles outlined in the Philotex judgement.
It is submitted that, although every auditor is aware of his overall duty to act
within the wider legal paradigm of South Africa, few auditors are aware of the
Philotex case or its direct impact on the audit opinion. By contrast, every auditor
is aware of the presence of statements of SAAS and SAAS 570. Every auditor
could automatically conduct his audit in accordance with the Philotex case and
in accordance with the wider legal paradigm. All that is required to achieve this
goal is the alignment of SAAS 570 with the Philotex case.
It is not necessary to educate every single auditor about the Philotex case or
its principles. In fact, such education may well be confusing to the auditor if the
dissonance between the audit and legal worlds is not resolved. It is much sim-
pler and more effective to synchronise SAAS 570 with the principles of the
Philotex case.
The final point raised in the defence of SAAS 570 is now addressed. Prior to
the adoption of SAAS 570, AU 294 was the auditing standard in force. This
standard did in fact support the auditor who qualified his opinion in the face of a
material uncertainty. AU 294 was synchronised with the legal paradigm. It is
argued in defence of SAAS 570 that at that time, auditors were not complying

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with AU 294. Auditors were not making the necessary qualifications to their
audit reports even when there was material uncertainty.
There was simply no real-world compliance with the guidance of AU 294. It
is argued that there was too much commercial pressure on the auditor by the
directors of entities. The directors of entities claimed that if the auditor qualified
the report, the qualification itself would cause the demise of the company. Trade
creditors, lenders and potential shareholders would withdraw their support for
the company due to the qualification. The directors claimed that the qualifica-
tion would be a self-fulfilling prophecy. They put considerable pressure on the
auditor not to qualify the audit report. In response, the auditors would simply
not comply with the requirements of AU 294 – even in cases where there was
going concern uncertainty.
Not only did the auditor not give the required qualification, it is argued that
there was also no disclosure in the financial statements by the directors of the
material uncertainties threatening the company. SAAS 570 attempted to address
this second issue of nondisclosure by the directors.
SAAS 570 wanted to ensure that the financial statements would disclose the
going concern problem and hence demanded that the auditor add an emphasis of
matter paragraph to draw attention to this disclosure by the directors. In this way
users would be made aware of the matters threatening the going concern status
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of the entity and the auditor would be instrumental in creating this awareness.
Since there was no qualification of the auditor’s report, the directors of an entity
would be far less resistant to an addition by the auditor of the emphasis of
matter paragraph.
This defence is now addressed. Firstly, it is interesting to note that in the
Philotex case itself, the auditors did qualify the audit report and hence did
comply with AU 294 – the standard in force at that time. It is ironic that, had
SAAS 570 been in force at the time of the Philotex case, the auditors might not
have qualified their opinion. Furthermore, in response to the assertion that a
going concern qualification is a self-fulfilling prophecy, it must be noted that the
audit opinion in the Philotex case was qualified for three consecutive years
immediately prior to the liquidation of the entity. If the qualification were a self-
fulfilling prophecy, it is expected that the entity would have been liquidated
soon after the first qualification appeared. The fact that the entity continued for
as long as three years after the first warning signal indicates that this argument
may be flawed. However, the most conclusive evidence against this argument is
set out in the auditing textbook The Principles and Practice of Auditing (Puttick
and Van Esch 2003:757):
Much has been written about the self-fulfilling prophecy of “going-concern” related
qualifications of audit reports, the argument being that should the auditor qualify
where uncertainties exist, this will surely lead to the appointment of a judicial man-
ager or liquidator. Reported research by R J Taffler and M Tseung (The Account-
ant’s Magazine, July 1984) revealed that this is not necessarily the case, in that out
of a group of 86 public companies which were liquidated, only 24% had a going-
concern qualification in their last financial statements prior to failing. A more

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disturbing finding was that only 20% of companies whose financial statements
carried a going-concern qualification were subsequently declared bankrupt.
The auditor should not refrain from issuing a modified report on the grounds that
this may lead to the demise of the entity.’
SAAS 570 (SAICA 2000) was introduced to increase the disclosure of factors
threatening the going concern status of the entity. However, it is doubtful that
this has been achieved in practice. The nature of the disclosure currently given
by directors in the financial statements is of very limited use.
Furthermore, the auditor’s emphasis of matter note, drawing attention to the
directors’ disclosure, is very mild and provides little warning in itself. The
auditor has passed on the obligation to warn the shareholders about material
uncertainty to the directors, and the directors often do not fulfil this task ad-
equately.
A review was performed of a random sample of financial statements from the
2002 financial year to observe the level of warning given by directors and
auditors. Examples of poor disclosure and inadequate warning in this regard
may be found, amongst others, in the 2002 annual reports of Admiral Leisure
World Limited (2002), Trematon Capital Investments Limited (2002), MGX
Holdings Limited (2002), Gilboa Properties Limited (2002), Zaptronix Limited
(2002) and Zeltis Holdings Limited (2002).
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In an annual report of Zaptronix Limited (2002:4), the following warning was


given by the auditors in their audit report:
Without qualifying our opinion, we draw attention to paragraph three of the “Direc-
tors’ Responsibility Statement”, which indicates the existence of a material uncer-
tainty which may cast significant doubt about the company’s ability to continue as a
going concern.
Hoping to obtain information regarding the nebulous material uncertainty
mentioned by the auditors, a reader would refer to the Directors’ Responsibility
Statement itself, located on page 2 of the annual report. However, one would
find the information provided therein of very limited use:
The financial statements have been prepared in conformity with South African State-
ments of Generally Accepted Accounting Practice. Although the financial statements
are prepared on a going concern basis the ongoing business is dependent on the con-
clusion and fulfilment of significant contracts in the near term.
The 2002 annual report of Zeltis Holdings Limited is no more informative. On
page 11 of the annual report, the auditors’ warning is equally mild:
Without qualifying our opinion above, we draw attention to the fact that the Annual
Financial Statements have been prepared in accordance with the accounting princi-
ples applicable to a going concern. This assumes, amongst other things, that the en-
tity will be able to generate sufficient profits and cash flow in the foreseeable future
to meet its obligations in the normal course of business. In this regard, we draw
users’ attention to the disclosures made by the directors in their report.
Reading the Report of the Directors of Zeltis, located on page 8 of the annual
report, the lack of adequate disclosure and sufficient warning is plainly evident:

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The directors have considered their responsibilities in terms of the going concern of
the company. Cash flow forecasts and budgets have been instituted, along with better
financial disciplines. The directors believe that these steps, along with the continued
good performance of Denverdraft [a subsidiary of the entity], will ensure the com-
pany continues to trade for the forthcoming year.
This appears to be a completely inadequate warning regarding the factors
threatening the going concern status of the entity. In fact, there is simply no
mention of any such factors. All that is mentioned are management’s plans for
future continuance. These too are very vague and generic. Almost all companies
are involved in the preparation of cash flow forecasts. Almost all companies are
involved in the implementation of improved financial disciplines on an annual
basis. This is not at all specific to companies with a going concern difficulty.
The disclosures referred to above simply do not provide any meaningful in-
formation regarding the factors that threaten the going concern status of the
entity. They fall short of the level of detail that is required by SAAS 570.
Ironically, there appears to be no real-world compliance with SAAS 570,
despite the efforts of the standard to combat this very problem. This is not
unexpected – no director would boast about the difficulties facing the company.
No director would willingly offer information regarding the factors that threaten
his or her entity – certainly no director who has an interest in maintaining the
share price or market share of the entity.
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It appears that SAAS 570 has let the auditor ‘off the hook’, so to speak. Pre-
viously the auditor did not comply with his obligation to qualify the audit report
as required by AU 294. As a result, SAAS 570 has shifted the onus of alerting
the members away from the auditor and onto the directors. The auditor no
longer communicates the going concern danger directly to the members by
means of a qualification. The directors must now warn the members. The
directors must now sound the warning bell, and all the auditor has to do is
emphasise that warning. However, it is clear that the warning issued by the
directors is often neither honest, nor informative, nor powerful enough.
It is argued by proponents of the standard that the motivation for SAAS 570
was pragmatic. It dealt with the reality of the time – directors were not pro-
viding disclosure and auditors, despite the guidance of AU 294, were not quali-
fying their audit opinions. The argument runs that SAAS 570 is simply trying to
improve the directors’ disclosure of the factors that threaten the going concern
status of the entity. It attempts this by forcing directors to disclose relevant
information and by encouraging the auditor to use an emphasis of matter para-
graph to draw attention to this disclosure. At the same time the directors of the
entity are appeased by the unqualified audit report now permitted. The defence
states that since auditors were not qualifying their reports in any event, the
decision to relax pressure on the auditor to qualify his report was no real loss to
the profession.
However, SAAS 570 has created a dissonance between the legal and auditing
worlds that was not present when AU 294 was in force. Previously the auditor
was encouraged by AU 294 either to qualify or not to qualify the report, depending

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Geva

on the circumstances. In SAAS 570, however, the focus is on drawing the


attention of users to the disclosure given by the directors. The focus has shifted
away from the qualification of the audit opinion.
The message sent out by SAAS 570 is a dangerous one. In the past, as sug-
gested by the advocates of SAAS 570, the auditor was not qualifying the audit
report, despite the fact that AU 294 was in force. Now, SAAS 570 no longer
requires the qualification of the audit report. In this way it allows the auditor to
enter into a tacit bargain: if the directors make the necessary disclosure, the
auditor will appease them by leaving the report unqualified. It appears that,
because the requirement to qualify was not complied with, the requirement has
been relaxed. A ‘second prize’ is now accepted – the standard settles for an
emphasis of matter paragraph.
If a law is not obeyed, one should not alter the law – one should clamp down
on those who do not comply. Similarly, if an auditor does not comply with an
auditing standard, the governing body should discipline the auditor. There are
numerous tools that the governing body is empowered to use in order to do this
– including quality control reviews and disciplinary hearings. However, to alter
the requirements of the auditor’s rulebook just because the auditor is not playing
by the rules should not be an option. This is especially so if the alteration creates
a dissonance with the legal world – a world to which the auditor owes his
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existence.

7 Conclusion
This article has exposed the dissonance between the auditing and the legal
paradigms in the context of the going concern problem. Currently there is a
possibility of an illogical situation: the directors of an entity may trade negli-
gently and/or recklessly, and yet the auditor issues a clean audit report. Direc-
tors must comply with an aspect of law, and yet the auditor, a legal messenger,
is not aligned with that law. Furthermore, in a situation where the Supreme
Court of Appeal does not consider an entity to be a going concern, the auditor’s
opinion may directly contradict the court and indicate that the entity is a going
concern. Regarding the vital going concern problem, it is submitted that under
SAAS 570 ‘Going Concern’, the auditor is not a sound messenger of the law.

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