An evaluation of the going concern principle on JSE-listed companies

Abstract

Failure prediction has long fascinated investors, managers, and academics. When a company becomes financially distressed or possibly even has to liquidate, the impact and economic costs are significant, and the owners of the company, its management and employees, capital markets, the fiscus, and the general society, all suffer the consequences. Despite the significant amount of research that has taken place over the last century, unexpected business losses continue unabated, and these are even expected to worsen as the rate of technology escalates, and world and economic conditions become increasingly unstable and unpredictable. It is therefore even more important now to identify appropriate indicators that will allow the users of financial statements to distinguish between successful and failed companies effectively and timeously. The remarkable number of companies that enter business rescue each year, the large number of companies that de-list from the Johannesburg Stock Exchange, and the fact that several companies are forced into liquidation annually, also led to this researcher questioning whether the going concern assumption still deserves its status as an underlying principle of financial accounting. The going concern principle should only be retained for the preparation of annual financial statements if it is relevant and valuable to the users thereof in making economic decisions. The literature review performed for this dissertation revealed that the majority of past research in a South African context has taken place using a matched-pair sampling technique. However, this design could potentially lead to sampling bias, and the results may be difficult to extrapolate to other entities, small businesses and unlisted companies. Furthermore, the financial ratios which are applied in the United States of America, Europe or Asia, may not be applicable to companies in South Africa, as economic and political conditions, infrastructure and capacity, capital availability, legislation and the application of accounting standards, are vastly different. There is also currently very little agreement and limited research regarding the continued applicability of the going concern assumption as an underlying principle of financial accounting: it is mostly accepted without being questioned.

Based on the gaps that were identified, this study has been designed as an evaluation, through the application of financial ratios, of the going concern principle as it applies to JSE-listed companies. Companies listed (or previously listed) on the Johannesburg Stock Exchange, were classified into three groups: (i) successful, (ii) struggling, and (iii) failed companies. The financial data for a sample of ten companies from each designation were then assimilated and averaged, and financial ratio analysis was applied to the results. The data were averaged to control, to some extent, for size and industry variances. The analysis was furthermore performed for two six-year time periods: 1998 to 2003, and 2013 to 2018. The duration of the time periods was set at six years to determine whether there were any discernible trends or patterns in the financial information or the financial ratios that could assist a decision-maker with distinguishing between successful and failed companies, preferably years in advance of failure occurring. These time periods were also selected to avoid periods where accounting changes (the adoption and implementation of International Financial Reporting Standard in 2005) and economic upheavals (the global recession of 2008 and the COVID-19 pandemic in 2020) may have led to abnormal results and higher-than-normal company failures. The study revealed that financial ratio analysis remains relevant and useful in the prediction of financial distress and potential failure and that, in a South African context, several financial ratios deliver reasonable predictive results, including the headline earnings per share, return on assets percentage, asset turnover, interest and finance charges as a percentage of long-term interest-bearing loans, operating cash flows-to-current liabilities, annual changes in net income, and the market-to-book ratios. The most significant and remarkably accurate predictor of financial failure, even several years before failure is officially recognised, however, was the Springate-model Zscore. The Springate-model Z-score was able to successfully distinguish between successful and failed companies across all years of both time periods of the empirical analysis, and could significantly improve the economic decision-making abilities of the users of financial statements in future. The study would further like to suggest that the going concern assumption is no longer required as an underlying principle of financial accounting. Instead, the management and auditors of companies should be tasked with clearly, unambiguously, and responsibly, explaining – with detailed supportive documents which may have been previously unavailable to the general public – why a company is able to continue for the foreseeable future as a going concern. It is hoped that a more demanding legal obligation for a going concern explanation will prevent the users of financial statements from having to ‘predict’ when corporate failure may be imminent, and to be able to make more informed economic decisions using the annual financial statements of JSE-listed companies.