The rules around when to issue a going-concern warning are, well, going a little haywire these days.
In an odd interplay of accounting and auditing standards, a new accounting standard meant to give investors more warning of when a company is in trouble could actually lead to less warning. It depends in large part on what audit regulators decide to do next.
The Financial Accounting Standards Board issued a new standard in 2014 that requires management to take the first step in warning investors if there is substantial doubt in a company’s ability to remain in business as a going concern. The going-concern warning has long been the duty of auditors as part of their assessment of a company’s financial statements, but auditors and others have advocated that management should be tasked with making the call.
FASB’s first exposure draft proposing a new standard dates back to 2008, when the financial crisis and ensuing economic strife led to new investor cries for more notice when a company is teetering at the edge of disaster. The board juggled numerous views on what should be required and whether to proceed with any requirement at all, and FASB changed course more than once on its way to the final rule issued last year.
Some are still unhappy that management is required to make the disclosure at all. “You don’t want management or the CEO to believe the company is going down the tubes,” says John Exline, global director for the Institute of Management Accountants. “You want them to have faith in their ability to turn it around. It’s a fine line between transparency and disclosure.”
Ultimately, FASB settled on requiring the disclosure when management determines there is “substantial doubt” in a company’s ability to keep up with its financial obligations. FASB defined substantial doubt as “probable,” says Joe Carcello, executive director of the Corporate Governance Center at the University of Tennessee.
The wrinkle is this: While auditing standards have used that same trigger of “substantial doubt” to instruct auditors to make the disclosure, the term has been interpreted in audit practice to mean “significant possibility,” Carcello says.
“[I]f the auditing literature is aligned with the new FASB standard, the number of going-concern reports in the United States would probably go down, some think by a lot.”
Joe Carcello, Executive Director, Corporate Governance Center, University of Tennessee
Most accounting and audit professionals believe “probable” is a higher threshold than auditors have used historically, Carcello says. “So if the auditing literature is aligned with the new FASB standard, the number of going-concern reports in the United States would probably go down, some think by a lot.”
That depends on how the Public Company Accounting Oversight Board decides to proceed. The PCAOB issued an alert to auditors soon after the FASB accounting standard became final to explain that auditors should plan to audit management’s going-concern claim as they would any other financial statement assertion, and continue to perform their own assessment under existing auditing standards as well.
That scenario is not on the immediate horizon, says Sara Lord, a partner with McGladrey, because the accounting standard does not take effect until after 2016—and she’s not hearing of companies planning to adopt it early. “So this is a little bit of a limbo period,” she says.
But preparers and auditors are starting to talk about how they might address the difference in threshold in the absence of any further guidance. “There is some evaluating being done to say is it the exact same standard that auditors are holding clients to today, or is it a different threshold?” Lord says. “I’m not sure if the standard is higher or lower, but some are questioning the interplay of the new standard with practice historically.”
PCAOB ADVICE ON AU SEC. 341
Below is an excerpt from the PCAOB’s staff alert on the auditor’s consideration of a company’s ability to continue as a going concern.
On August 27, 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-15 to communicate amendments to FASB Accounting Standards Codification Sub-topic 205-40, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. The ASC amendments establish new requirements for management to evaluate a company’s ability to continue as a going concern and to provide certain related disclosures for financial statements prepared under GAAP. The ASC amendments are effective for the annual period ending after Dec. 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted.
International Financial Reporting Standards also have requirements for management to evaluate a company’s ability to continue as a going concern and provide certain related disclosures for financial statements pursuant to International Accounting Standards No. 1, Presentation of Financial Statements. These requirements differ from the requirements in the ASC amendments.
In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with the applicable financial reporting framework, including whether they contain the required disclosures, auditors should assess management’s going concern evaluation. In making this assessment, the auditor should look to the requirements of the applicable financial reporting framework.
In addition, auditors should continue to look to the existing requirements in AU sec. 341 when evaluating whether substantial doubt regarding the company’s ability to continue as a going concern exists for purposes of determining whether the auditor’s report should be modified to include an explanatory paragraph regarding going concern. The AU sec. 341 requirements for the auditor's evaluation, and the auditor’s reporting when substantial doubt exists, have not changed and continue to be in effect. Under AU sec. 341, the auditor’s evaluation of whether substantial doubt exists is qualitative based on the relevant events and conditions and other considerations set forth in AU sec. 341. Accordingly, a determination that no disclosure is required under the ASC amendments or IAS 1, as applicable, is not conclusive as to whether an explanatory paragraph is required under AU sec. 341. Auditors should make a separate evaluation of the need for disclosure in the auditor’s report in accordance with the requirements of AU sec. 341.
The PCAOB staff is currently reviewing AU sec. 341 and evaluating potential revisions to that auditing standard, including consideration of accounting standards and input from the Board’s advisory groups. Any proposed revisions to AU sec. 341 would be made through the PCAOB’s standard-setting process, including the opportunity for public comment.
Further guidance is still a possibility, after the PCAOB opened a project to take a fresh look at its auditing standards in light of the new accounting standards. The board plans to publish a staff consultation paper in the first half of 2015. That will provide at least an early indicator of what the PCAOB is thinking to do.
One option, Carcello says, is for the PCAOB to make no changes to standards, leaving potential differences in how they might be interpreted. “The perception is that the probability threshold used by auditors is below the ‘probable’ threshold in the accounting literature,” he says. “Assuming that is accurate, you’d have more going-concern opinions in audit reports than management suggests exist, because they would be using a higher probability threshold.”
Another option, he says, is to change the auditing literature to align it more explicitly with accounting literature. That idea might be popular with preparers and auditors, but investors would likely get even less warning than they do today since auditors would follow that lower probability threshold, Carcello says. A hybrid approach would be to make the guidance consistent with respect to a going-concern warning, but also require auditors to warn investors if they have significant uncertainties that don’t rise to the level of a going-concern disclosure.
For private company audits, the American Institute of Certified Public Accountants through its Auditing Standards Board has already issued some guidance meant to steer auditors through the present differences in accounting and auditing standards. That’s not authoritative for public company audits, says Mike Santay, a partner with Grant Thornton, but it can be helpful to auditors seeking ideas on how to respond to both accounting and auditing standards.
“The PCAOB alert doesn’t try to give views on the differences that have arisen in the threshold of substantial doubt,” he says. “It will be interesting to see how this plays out. We don’t have any real life experiences to share.”
Nick Tsafos, a partner with audit firm EisnerAmper, says he’s not as concerned about the threshold to trigger disclosures as the time horizon of the assessment. Under accounting rules, management is told to look out one year from the date financial statements are issued. Auditors, however, are required to look out one year from the balance sheet date.
“For a public company, that can be a difference of as much as two months,” he says. And as anyone around in September 2008 will remember, a lot of financial crisis can happen in two months.
Scott Lehman, a partner with Crowe Horwath, also isn’t as concerned about the threshold difference. “Instead of raising the bar, this levels the playing field,” he says. “Now management and auditors both have this responsibility.”