Disclosures regarding a company’s financial condition and ability to continue as a “going concern” are paramount to providing important and transparent information to the investing community.

Speaking bluntly, if a business is in financial trouble, then management must say so to stakeholders. This is not optional; it is required as a disclosure under Generally Accepted Accounting Principles. Some registrants acknowledge and disclose problems and, unsurprisingly, soon thereafter file for bankruptcy. Others do not disclose a problem, then, surprisingly, file for bankruptcy.

Speaking bluntly, if a business is in financial trouble, then management must say so to stakeholders. This is not optional; it is required as a disclosure under Generally Accepted Accounting Principles.

In the current economic environment, investors are on high alert for these critical disclosures, as the uncertainty of the COVID-19 pandemic has significantly threatened the financial health of many companies.

In recent years, the responsibility over disclosures regarding a company’s ability to continue as a going concern has shifted to a shared burden between auditors and management — and timely disclosure of going concern issues is now a management responsibility.

However, a review of public filings by companies that have recently filed for bankruptcy protection illustrates diversity in practice, including instances in which companies sought bankruptcy protection after issuing financial statements that lacked adequate disclosure about the entity’s ability to continue as a going concern.

Below is a summary of the financial reporting rules regarding going concern disclosures, recent disclosure examples, and key factors that counsel and their clients should consider during these times as management prepares financial statements and related disclosures.

Management’s responsibility

Following years of growing wariness from the investment community surrounding the adequacy of companies’ going concern disclosures, the Financial Accounting Standards Board issued a new set of rules related to going concern disclosures.

For many years, the responsibility to issue going concern disclosures was left to the auditors. However, with the issuance of the FASB’s Accounting Standards Codification 205-40 Going Concern, effective December 2016, management is also required to evaluate conditions or events at each reporting period that raise substantial doubt about the company’s ability to continue as a going concern.

According to ASC 205-40, when completing a going concern analysis, management should consider key factors, including the company’s current financial condition, conditional and unconditional obligations due or anticipated to be due within one year of the financial statements’ issuance date, and funds necessary to maintain the company’s operations.

Should management identify conditions and events — such as negative financial trends related to operating losses or negative cash flows, loan defaults, work stoppages, other labor challenges, or external factors such as legal proceedings or similar matters — that jeopardize the company’s ability to operate, it is required to make certain disclosures in the financial statements, including:

the nature of the principal conditions or events that raise substantial doubt;
management’s evaluation of the significance of those conditions and events;
management’s plans that have alleviated substantial doubt, or if it is 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.

Going concern analyses, disclosures

Both auditors and management have an obligation to evaluate the company’s ability to continue as a going concern, although the required frequency of such assessments differ.

The auditor’s assessment considers the 12-month period immediately after the date of the annual financial statements (i.e., balance sheet date). However, management’s evaluation must consider the 12-month period immediately following the financial statement issuance date, including an assessment for interim financial statements.

Because a majority of public registrants operate under a calendar-based fiscal year, many recent annual financial statement filings were issued before the World Health Organization declared the COVID-19 outbreak a pandemic on March 11. Therefore, while many audits will not be required to address going concern issues until the end of 2020, management must address these sensitive issues on a quarterly basis in conjunction with upcoming Form 10-Q filings.

Recent disclosures, diversity in practice

The COVID-19 pandemic has significantly impacted the global economy in early 2020. In fact, according to Audit Analytics, as of May 20, 30 publicly traded companies had already received audit opinions with going concern disclosures that cited COVID-19 as a contributing factor.

Many well-known companies, such as JC Penney and Gold’s Gym, have already filed for bankruptcy protection, and the number of bankruptcy filings is expected to increase significantly.

While the current economic outlook is uncertain, one thing that is certain is that there will be increased scrutiny of going concern disclosures leading up to a public registrant’s bankruptcy filing.

We have reviewed a sample of public filings related to companies that have recently sought bankruptcy protection and noted a diversity in practice.

For example, on April 14, Frontier Communications Corp. filed for Chapter 11 bankruptcy protection, just several weeks after the company filed its Form 10-K for fiscal year 2019, in which both management and the auditors disclosed substantial doubt regarding the company’s ability to continue as a going concern.

In its Form 10-K filing, Frontier disclosed that it could be adversely impacted by weak economic conditions and disruptions in the industry, including political instability and health concerns, such as the ongoing COVID-19 pandemic.

Similarly, the company highlighted the risk the COVID-19 pandemic presents to its key suppliers’ and vendors’ ability to provide products and services, which could increase costs or cause disruptions to Frontier’s services.

In contrast to Frontier’s going concern disclosures and subsequent bankruptcy protection filing, Whiting Petroleum Corp. filed for Chapter 11 bankruptcy protection on April 1, shortly after issuing its 2019 annual report on Feb. 27, which notably lacked any disclosure of substantial doubt regarding Whiting’s ability to continue as a going concern.

Notably, similar to Whiting, other companies have recently filed for bankruptcy protection shortly after issuing financial statements that lacked going concern disclosures. Diamond Offshore Drilling, for example, filed for Chapter 11 bankruptcy protection on April 26, while none of its quarterly or annual reports during the 12-month period preceding the bankruptcy protection filing included a going concern disclosure from either management or the auditor.

Going concern analyses are inherently complex and require significant management judgment. While we do not have all of the facts and circumstances that may have supported the timing of disclosures noted in the examples above, financial statement disclosures leading up to bankruptcy filings will certainly be subject to additional scrutiny by regulators and investors during these unprecedented times.

Considerations for management, corporate counsel

Management’s responsibility to assess a company’s ability to continue as a going concern and disclose the results in its quarterly and annual reports inherently increases the risk for management and the company, as there can be significant consequences for failing to accurately assess or disclose these issues.

The failure to provide an 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). The company could face costly SEC investigations or civil litigation actions based on incomplete or inaccurate disclosures.

Corporate counsel can assist with management’s assessment of the company’s ability to continue as a going concern and evaluate whether the company has appropriate in-house expertise, qualifications and tools to perform such an analysis.

Similarly, counsel can help clients navigate the disclosure drafting process, ensuring liquidity and risk factor disclosures required in public filings align with management’s going concern analyses and related disclosures, if any.

Disclosing substantial doubt about a company’s ability to continue as a going concern can result in extreme challenges for the business, such as credit downgrades, loss of customers, or a tightening of restrictions from vendors. Nevertheless, it is crucial during these uncertain times that management accurately and completely assesses the company’s ability to continue as a going concern and provide any such disclosures on a timely basis, as required by GAAP.

Michael W. Phillips, a CPA, is managing partner of Floyd Advisory, a consulting firm in Boston and New York City that provides financial and accounting expertise. Ryan M. Brown is a manager at Floyd Advisory. Sarah K. Woznicki, a senior associate, also contributed to the above article.