New going concern rules: Are your clients ready?

In recent years, the investment community has grown increasingly concerned about perceived inadequacies in going concern disclosures in financial statements and audit opinions.

In an attempt to address some of those concerns, in August the accounting standard setters at the Financial Accounting Standards Board, or FASB, issued new rules related to going concern disclosures that introduce new responsibilities for management.

Counsel focusing on corporate and securities law, as well as company executives, need to be aware of the impact of these new rules, which are effective beginning in 2016. The responsibility for the adequacy of going concern disclosures will no longer solely rest with financial statements auditors. Instead, along with possible related legal liability risks, the responsibility will be shared with management.

Investor concerns with existing rules

Under current auditing standards, auditors need to evaluate information that contradicts an entity’s ability to continue to meets its obligations as they become due without taking significant actions outside the ordinary course of business (such as a debt restructuring or disposition of assets).

Specifically, auditors have the responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time (not to exceed one year from the date of the financial statements). The auditor makes that determination after performing the audit procedures designed to test management’s assertions in the financial statements.

Should substantial doubt exist, the auditor assesses the adequacy of financial statement disclosures regarding such concerns, and includes an explanatory paragraph in the audit opinion.

Investors view these “going-concern” opinions from auditors as a red flag and a potential indicator of pending bankruptcies. However, many in the investment community have grown wary of the ability of auditors to accurately assess going concern issues, especially given that few large companies that filed for bankruptcy during the financial downturn had received a “going-concern” opinion.

A study by Audit Analytics revealed that, from 2000 to 2010, approximately 40 percent of companies that filed for bankruptcy were not given a “going concern” audit opinion by their auditors prior to the filing.

Importantly, prior to issuance of the FASB’s new rules discussed below, auditors were solely responsible for going concern assessments under generally accepted auditing standards, or GAAS, while generally accepted accounting principles — GAAP — lacked any such requirement of management.

Although auditors may have required management to address going concern issues in management representation letters, GAAP did not include any such requirements. Many high-profile investors have been candid in their assessment of the audit industry’s ability to successfully identify going concern issues, including a senior portfolio manager with the California Public Employees’ Retirement System, who was quoted in the Wall Street Journal as saying, “You have to be dangling off a cliff, hanging on by your fingernails before the auditor blows the whistle.”

Shifting responsibilities

Many also questioned whether management, and not the auditors, was more suited to perform its own going concern analysis.

The FASB was concerned whether the lack of specificity in GAAP regarding management’s responsibility for going concern assessments resulted in diversity in practice for these important disclosures.

In fact, in 2008 the FASB issued an exposure draft with the intent of introducing going concern assessment requirements into GAAP. While the 2008 exposure draft did not make it through to final guidance, the FASB tried again and issued a similar exposure draft in 2013.

Normally, attempts by the FASB to introduce new accounting guidance are met by the accounting industry with a level of skepticism and substantial debate about the merits of the proposed changes. However, not surprisingly, the accounting industry, including the Big 4 public accounting firms, overwhelming supported an opportunity to share responsibility for going concern assessments and welcomed the FASB’s proposed changes with open arms.

Although there are those skeptical of the efficacy of the new rules given inherent management bias, effective with the implementation of the FASB’s new guidance 2016, the responsibility for going concern assessments and disclosures will no longer be limited to auditors, as those requirements will also become part of GAAP and by extension will become management’s responsibility.

The new rules

Both public registrants (SEC filers) and private companies will need to adhere to the new rules. The guidance will require management, at each annual and interim reporting period, to evaluate conditions or events that raise substantial doubt about the company’s ability to continue as a going concern.

Substantial doubt exists when it is probable that an entity will be unable to meet its obligations for the 12-month period from the date the financial statements were issued or available to be issued.

Events or conditions to consider include internal matters such as negative financial trends related to operating losses or negative cash flows, loan defaults, or work stoppages and other labor challenges. It’s also important to consider external factors such as legal matters or legislation that may result in a significant loss of business.

If those types of events and conditions are identified and raise substantial doubt about an entity’s ability to continue as a going concern, management will be required to disclose the following in the financial statements:

•         The nature of the principal conditions or events that raise substantial doubt;

•         Management’s evaluation of the significance of those conditions and events;

•         Information regarding management’s plans that have alleviated substantial doubt, or if it’s not probable that management’s plans will be effective in alleviating substantial doubt, information regarding plans to mitigate the conditions or events and an affirmative statement that there is substantial doubt about the company’s ability to continue as a going concern.

As companies prepare for the implementation of the new requirements, there are many questions that management and counsel should be considering:

•         Do they have the in-house expertise, qualifications and tools to adequately perform the analyses?

•         Do they need to implement changes in the company’s internal controls over financial reporting to address the new GAAP requirements?

•         How do the new disclosures interact with other liquidity and risk factor disclosures already required in a Form 10-K filing?

•         How does management balance the new requirements with the disclosure of potentially sensitive information that could put them at a competitive disadvantage?

Increased legal risk for management? 

Inherently, any analysis related to an entity’s future financial performance and liquidity position is a complex and judgmental endeavor, and for years auditors have been balancing the risks related to “going concern” audit opinions.

A failure to identify going concern issues and include a related disclosure in the audit opinion could open auditors up to significant criticism or legal liability. Conversely, audit clients are understandably resistant to “going concern” audit opinions, which could lead to a damaged client relationship.

Management will now be facing a similar dilemma. The disclosure of going concern issues could become a self-fulfilling prophecy if the company is then challenged with resulting credit downgrades, a loss of customers, or tightening restrictions from vendors.

However, the failure to properly predict and disclose these issues could also have significant consequences. The lack of adequate disclosure followed by significant financial difficulties or a bankruptcy filing could solicit allegations of fraud in the context of SEC Rule 10b-5 (Employment of Manipulative or Deceptive Practices), potentially leading to costly SEC investigations or civil litigation actions.

Although the new rules will be effective for financial reporting periods beginning in 2016, counsel and their clients should begin to assess the impact of the new guidance and consider plans for initial implementation and mitigation of any increased legal risks.

Michael W. Phillips, CPA, CFF, and Jesse J. Gillett, CPA/ABV, CFE, are with Floyd Advisory, a consulting firm providing financial and accounting expertise in business strategy, valuation, SEC reporting and transaction analysis.