Going Concern – A Fresh Look
By Timothy Landry, Senior Manager, Assurance Services and Ted Lucas, Senior Manager, Assurance Services
With much uncertainty in the economic environment over the past numbers of years, particularly the recession and decline in many Company’s stock portfolios; individuals and organizations have become more cautious and are demanding more diligence around a Company’s ability to continue as a going concern. Particularly after years of “playing it safe”, now is the time investors are looking to expand their portfolios and companies are looking to grow and take advantage of the modestly increasing economic environment.
However, due to the number of company collapses over the past five years, the investing community and audit committees are looking to the auditors and asking: What could have been done differently? Where were the signs? If only we knew!
As a result of these concerns, the financial community provided the FASB feedback stating that the current guidance under US GAAP was lacking clarity as to when and how going concern uncertainties should be disclosed within a Company’s disclosures.In response, the FASB issued proposed guidance addressing management’s responsibilities in evaluating going concern uncertainties of reporting entities.
Within this article we will begin by briefly describing some common indicators of going concern uncertainties, followed by the proposed guidance and a discussion on what it means to the professionals.
One of the most common indicators of going concern uncertainties is shrinking working capital, which includes a lack of quick assets (i.e. cash, accounts receivable, and inventory) and the stretching of accounts payable. Declining cash flow trends may likely appear sooner than declining profits. All of these indicators may indicate that the Company has the inability to fund continued operations.
Another common indicator is fully utilized lines of credit and/or long-term debt.These types of indicators are easy to identify, and auditors recognize them through routine analytical procedures.
Other types of common indicators include the downsizing of workforce through reduction in programs or employee turnover with an evident lack of replacement; one-time sales of company assets that will reduce a future revenue stream going forward; the lack of performance on revenue targets; and having a large quantity of top products at the end of the product life cycle.
The Proposed Guidance
The proposed guidance will seek to include management in the process and clarify certain assessment guidelines. If adopted, it will significantly change the going concern assessment process, such as requiring going concern uncertainties to be evaluated on an interim and annual basis as opposed to the long-time requirement that companies evaluate it once a year or when events dictate an additional evaluation.
Also included in the proposed guidance is the need for reporting entities to have note disclosures addressing going concern uncertainties. Companies will need to evaluate if it is more-likely-than-not that the reporting entity will be unable to meet its obligations within twelve months after the financial statement date without taking actions outside the ordinary course of business; and if it is known or probable that the reporting entity will be unable to meet its obligations within twenty-four months after the financial statement date without taking actions outside the ordinary course of business, as defined by the proposed guidance.
If either of these scenarios prove to be evident, specific note disclosure will be required and must include 1) the principal conditions and events that give rise to the potential inability of the reporting entity to meet its obligations; 2) the possible effects those conditions and events could have on the reporting entity; 3) management evaluation of the significance of those conditions and events; 4) mitigating conditions and events; and 5) management plans that are intended to address the potential inability of the reporting entity to meet its obligations. In addition, public companies would need to disclose that substantial doubt exists as to their ability to continue as a going concern within 24 months after the financial statement date.
What Does this Mean for Professionals
The negative implications for not recognizing and reporting going concern uncertainties can be substantial. One of the most significant implications to not reporting a going concern uncertainty is the misrepresentation to the existing and potential stakeholders on the long-term viability of a company and the basis of accounting for the valuation of assets and liabilities. This could result in lack of confidence in the auditor, which could sink audit firms in the court of public opinion.
As it currently stands, auditors alone have the responsibility for assessing going concern uncertainties.Although the proposed guidance would not change the auditors’ responsibilities, it will add a level of consistency through the application of the guidance and the assessment of going concern uncertainties.Further and more significantly, the proposed guidance will put emphasis on management’s responsibility for the evaluation of going concern uncertainties and the related note disclosures. As opposed to performing the assessment independently, the auditor will need to assess management’s analysis.This assessment will include scrutinizing the assumptions used by management, particularly where the proposed guidance has redefined the probability threshold and the period of evaluation.
There are certain complexities with the proposed guidance that many professionals may question. For instance, whether the new time period of twenty-four months is too long to predict?Or whether the distinction between what is “more-likely-than-not” or “probable of occurring” is concisely defined in the proposed guidance?Or how to determine what is “in the ordinary course of business”?These questions can lead to subjective conclusions and possible inconsistencies across entities, both of which pose new challenges for management and auditors.
With the new economic frontier investors are wary and audit committees are scrutinizing the financial results of companies more and more; and uncertainties in a company’s ability to continue as a going concern can come as a surprise to some, with little warning.Although the level of scrutiny an auditor puts on the evaluation of going concern uncertainties wouldn’t change, the hopes of putting an emphasis on management’s responsibility and added required disclosures will provide the transparency the investors and audit committees need to make informed decisions, as well as help companies navigate through troubled times.