Creditors, management teams, business owners and investors depend on accurate and reliable financial information to make informed decisions. Management teams and business owners may use financial information to decide whether to expand operations in a new territory or make hiring and termination decisions. Creditors and investors may use financial information to determine whether to lend or invest funds with a company. It is key that financial reporting be both transparent and consistent to aid the users of financial statements in making these strategic choices.
One accounting principle that provides users of financial statements with transparent and consistent information is the going concern considerations included in Accounting Standards Codification (ASC) 205-40. The standards in ASC 205-40 define management’s responsibility to evaluate whether there is substantial doubt about an organization’s ability to continue as a going concern and provide guidance on related footnote disclosures that may be required. As defined in ASC 205-40, substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or available to be issued). It is essential for management teams to understand these responsibilities and proactively consider the financial challenges of their businesses as they are looking to strategically grow and operate their companies.
The following sections will highlight potential indications of substantial doubt that management teams may consider in their analysis, as well as potential ways management may alleviate substantial doubt.
Potential indications of substantial doubt could include:
- Negative working capital ratio – A negative working capital ratio means that the company’s current assets will not cover their current liabilities. “Current” being defined as assets that can be liquidated easily within the next 12 months and liabilities that are due within the next 12 months.
- Negative operating cash flows – Negative operating cash flows are very common for companies that are startup in nature or looking to achieve rapid growth. These companies may be investing in research and development related to new technologies or the growth of a sales team that is intended to expand the company’s footprint. Although negative operating cash flows may be normal for companies in the startup or emerging growth space, they could create substantial doubt about the going concern of the company, if other factors don’t alleviate that doubt.
- Debt maturities – Upcoming debt maturities can create a particular hassle when it comes to issuing financial statements. A company may want to issue financial statements without an emphasis of matter* related to substantial doubt of a going concern because they are intending to restructure their debt that is coming due. However, the banks involved may require the issued financial statements before they’re willing to approve the debt restructuring. If there is no guarantee that the debt will restructure and payment terms will be extended, substantial doubt may need to be indicated in the financial statements.
- Covenant requirements – A company that fails to meet their covenant requirements could trigger an acceleration of debt maturities. This potential indication of substantial doubt must be considered for not only covenants as of the reporting date of the financial statements but also covenants requirements that are occurring within the 12-month evaluation period following the issuance of the financial statements.
- Failure to pay vendors – In some situations, a startup company may need to delay payments to vendors or compensate vendors or employees through the issuance of equity instead of cash payments. At times, these practices may be tools used to stretch operations until additional funds come in from creditors or investors, but it could also be an indication the company is struggling to operate.
Potential ways substantial doubt could be alleviated:
- Raising additional funds – The company would need to have signed documents proving commitment and/or the cash received and conclude that the amount of the funds provides sufficient runway to operate for the next 12 months.
- Support letter from an owner or investor – In some cases, the timing of a fund raise my not close before financial statements need to be issued. In this case, management may be able to provide a support letter from an existing owner or new investor. The support letter would demonstrate the owner or investor’s intent to provide support to the company to assist in covering operating, investing, and financing activities for the 12-month period. Additional evidence of the owner or investor’s ability to provide support would also be required to alleviate the substantial doubt. The ability to provide support could include financial statements of the supporting party or bank/investment statements proving the supporting party has sufficient access to funds.
- Restructuring of existing debt – In situations where debt is coming due, a company may be able to restructure their debt agreements.
- Flexible costs that can be cut while maintaining current operations – The company may have costs included in their operating budget that are optional or included for aggressive growth plans that can be reduced or removed to help stretch the company’s operations until additional capital can be raised, or debt financing can be obtained.
- Evidence of new customer contracts / expanded pipeline – Management may be able to show signed contracts to support trends in revenue growth which can be utilized to support changes in expected operating cash flows compared to the company’s historical trends.
There is no bright line test when it comes to evaluating whether a company has substantial doubt about their going concern. Potential scenarios such as the above may provide an indication regarding the on-going stability of the company. In many circumstances a business may have disclosures related to substantial doubt every year of their operations. This may be anticipated by both management and investors as the company aims to grow and has planned for additional capital to be raised to fund the business’s growth. The key is to openly communicate among management, investors, bankers, and audit firms, proactively review the financials and avoid unexpected surprises.
*An emphasis of matter refers to a separate paragraph highlighting the substantial doubt related to going concern in the audit opinion, review or compilation report that is included with the company’s financial statements. Going concern considerations are applicable for all levels of attestation a company may engage to receive from their accounting firm.
