Under U.S. GAAP, it is presumed that an entity will continue as a going concern unless and until the entity’s liquidation becomes imminent. To continue as a going concern means that the entity will be able to continue operating for a period of time sufficient to carry out its commitments, obligations, etc. Said another way, the company will not have to liquidate in the foreseeable future. As long as it can be presumed that an entity will continue as a going concern, the entity continues to prepare its financial statements in accordance with U.S. GAAP. If liquidation ever becomes imminent, the entity should prepare its financial statements under the liquidation basis of accounting.
A missing piece of U.S. GAAP
The accounting requirement above is not new and it has not changed. However, in 2008, as a result of the tumultuous economic environment, the regulators took a fresh look at the going concern assessment and disclosure requirements.
Their main problem: there were no required disclosures or early warning system to alert investors and other users of the financial statements to the fact that the company (or its auditors) had concerns about the company’s ability to continue as a going concern. Financial statements could be prepared under traditional U.S. GAAP reporting one period and the liquidation basis of accounting the next. The only guidance that existed was SEC guidance on what it would expect to see disclosed should an auditor’s report include an explanatory paragraph reflecting the auditor’s substantial doubt about an entity’s ability to continue as a going concern.
The second problem regulators faced was that there was no explicit requirement for prepares of financial statements to assess their ability to continue as a going concern – the ownership for that evaluation rested with the auditors under either PCAOB or AICPA auditing standards. If users of financial statements wanted to see more information regarding this crucial piece of information, they would need to read the auditor’s report and look for an explanatory paragraph.
Enter ASU 2014-15
In response to these problems, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which amends ASC 205, Presentation of Financial Statements, specifically ASC 205-40. This ASU requires that management evaluate whether there are conditions that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. This assessment should be made each annual and interim reporting period. If there is substantial doubt, the ASU provides the required disclosures, which vary depending on whether management has a plan to mitigate the doubt and whether or not the successful implementation of that plan is probable.
How do you know if there is substantial doubt? The FASB says that substantial doubt exists when relevant conditions and events indicate that 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.
If there is substantial doubt about the entity’s ability to continue as a going concern, management must next consider if they have a plan in place that is intended to mitigate the adverse conditions or events. If it is probable that management’s plan will be effectively implemented and it is probable that management’s plan will mitigate the conditions that raise the substantial doubt about an entity’s ability to continue as a going concern, the entity should disclose the following:
- The principal conditions or events that raised substantial doubt, before consideration of management’s plans,
- Managements evaluation of the significance of those conditions or events; and
- Managements plans that alleviated the substantial doubt.
If it is not probable that management will be able to effectively implement its plan or if it is not probable that the plan will mitigate the relevant conditions that gave rise to the substantial doubt, the entity should also disclose a statement indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued.
Going Concern and the Audit
What about the auditors? Well the PCAOB auditing standards have not changed. In response to this guidance issued by the FASB, the PCAOB released PCAOB issued Staff Audit Practice Alert (SAPA) 13, Matters Related to The Auditor's Consideration of A Company's Ability to Continue as A Going Concern. This document reminds auditors to continue to follow the existing PCAOB guidance when considering a company’s ability to continue as a going concern. The document also points auditors to the appropriate framework (U.S. GAAP or IFRS) when assessing management’s evaluation and disclosures. Because the PCAOB did not revise its guidance, it is worth noting that the PCAOB requires that, for the auditor’s report, the auditor consider the entity’s ability to continue as a going concern for a period of one year from the balance sheet date. Meanwhile, the FASB guidance requires that management’s evaluation be for the one year period from the issuance of the financial statements.
For non-PCAOB audits, the AICPA’s Auditing Standards Board (ASB) issued Statement on Auditing Standards No. 132 (SAS 132). The standard aligns the existing guidance issued by the ASB more closely with the guidance issued by the FASB in ASU 2014-15 as well as the GASB guidance for state and local governments. The standard now requires auditors to separately conclude on management’s assessment of their ability to continue as a going concern and the auditor’s assessment of the entity’s ability to continue as a going concern, including gathering appropriate evidence to evaluate management’s plans to alleviate substantial doubt.
Is it working?
Well, in a word, yes. But it has come at a cost to companies, because the announcement usually comes with a sharp decline in their share price.
There have been some examples recently of companies warning their financial statement users that the company is experiencing financial difficulty. For instance, back in April 2017, we wrote about Toshiba raising the red flag and warning investors of its substantial doubt over its ability to continue as a going concern. Most recently, iHeartMedia, the largest operator of commercial radio stations in the United States, warned its investors and users of financial statements that it had substantial doubt over its ability to continue as a going concern for a period of 12 months following the release of their 10-Q on November 8, 2017. In its disclosures, it lists the conditions and events that management considered and provides insight into the particular facts and circumstances that raised this substantial doubt. Some of the reasons include the decline in revenues and the substantial amount of debt coming due in the near term. Their disclosures indicate their future success as a company will be dependent on their ability to refinance this debt before it comes due and warns that bankruptcy may be a viable option.
The result of this announcement? iHeartMedia’s share price fell by about 54% the day of the announcement. Message received.
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