Management, not auditors, will soon be expected to give investors an early warning that the company is headed for trouble and may not be able to remain in business.
The Financial Accounting Standards Board recently adopted a new standard that directs management to determine each reporting period whether there are conditions or events that raise “substantial doubt” about the company’s ability to continue as a going concern in the coming year. That duty has traditionally fallen to auditors, who are required under their own standards to assess annually and include a note in their audit report if they believe the company can’t survive another year.
The new accounting standard tells management it’s their job to do the assessment first, says Beth Paul, a partner with PwC. FASB says it’s not uncommon for companies to provide some type of disclosure in footnotes when a company’s condition has worsened, but with no prior guidance in GAAP to direct it, there was no consistent approach. “For companies, this now will provide a standard that hopefully will promote consistency of the timing and the content of the disclosure,” she says.
When considering whether there’s substantial doubt about a company’s ability to remain a going concern, companies will be allowed to take into account any plan management might have to head off disaster, but that won’t absolve them of their duty to let investors know what’s happening. The new requirement says even if management’s plan is thought to be foolproof, investors are entitled to know that there are conditions or events that raise substantial doubt, how significant they are stacked against the company’s obligations, and that management is working on a plan to mitigate them.
Two FASB members, Tom Linsmeier and Larry Smith, dissented from the final standard. Linsmeier says requiring disclosure only after it’s probable a company will default only confirms what investors probably already suspect or know. He also believes the disclosure belongs in management discussion and analysis, where it would be subject to a safe harbor for forward-looking information. Smith says FASB did too little to address concerns over the cost-benefit equation, and the new standard ultimately leaves investors with less in the way of improved early warning disclosures.
“One thing to be on the lookout for is whether auditing standards will need to change to bring the auditor expectation into alignment with the accounting literature.”
Chris Smith, Partner, BDO USA
The board heard plenty of debate over the wisdom or utility of requiring management to make early warning disclosures when management’s focus is to make the company successful. Chuck Evans, a partner at Grant Thornton, says that concern over a natural bias against considering the possibility of failure wasn’t given significant consideration in establishing the final requirement. “There are a lot of different areas where management has to make difficult estimates and assertions,” he says.
The standard takes effect for annual periods ending after Dec. 15, 2016, so calendar-year companies will be required to apply it for the first time to their 2016 financial statements. FASB left a long lead time, says Chris Smith, a partner at BDO USA, to allow auditing standards to catch up to the new accounting standard. “One thing to be on the lookout for is whether auditing standards will need to change to bring the auditor expectation into alignment with the accounting literature,” he says.
Aligning Audit Standards
The Public Company Accounting Oversight Board has a standard-setting project on its agenda to reconsider its going concern requirements for auditors after seeing FASB’s final accounting standard for management. “The accounting standard is more or less in alignment with how many firms had operationalized the going concern work effort from the auditing standpoint,” says Smith. “I think the accounting standard is going to be very familiar to a lot of auditors.”
GOING CONCERN DISCLOSURES
Below FASB provides details on requirements of the new going concern standard.
Evaluating Whether There Is Substantial Doubt
Under the new standard, an organization’s management will be required to evaluate whether there are conditions or events that raise substantial doubt about the organization’s ability to continue as a going concern for a period of one year from the date the financial statements are issued. The guidance will provide management with principles for evaluating whether there is substantial doubt by:
Providing a definition of the term substantial doubt and related guidance
Requiring an evaluation every reporting period, including interim periods
Providing principles for considering the mitigating effect of management’s plans.
Once the organization identifies conditions or events that raise substantial doubt, it then will be able to consider whether management’s plans can alleviate substantial doubt by mitigating the underlying conditions and events.
If substantial doubt is identified, and is not alleviated by management’s plans, the organization will include a statement in the footnotes indicating that there is substantial doubt about its ability to continue as a going concern for a period of one year after the date the financial statements are issued. Organizations also will need to disclose in the footnotes information that enables users of the financial statements to understand the following:
Principal conditions or events that raise substantial doubt
Management’s evaluation of the significance of those conditions or events in relation to the organization’s ability to meet its obligations
Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt.
Early on, FASB contemplated requiring management to look as far forward as two years, says Paul, but ultimately brought the time line back to one year, more consistent with the time line auditors have long followed. A key difference, however, is FASB’s standard requires management to consider a year forward from the date it will issue its financial statements. Auditors are required to look a year ahead of the balance sheet date. “It is a different assessment period, but now much closer to the current auditing standard,” she says.
Auditors are rejoicing the new requirement. “It’s about time,” say Scott Lehman, a partner with Crowe Horwath. “This started even before the PCAOB,” which sprang out of the Sarbanes-Oxley Act, he says. “Why are auditors responsible for trying to determine management’s ability to continue as a going concern, when management doesn’t have to do the same? The auditing profession has been rallying to say we need to be on the same page.”
Because auditors are responsible for doing their own independent evaluation and making their own disclosure if warranted, auditors were reliant on management to provide the information necessary to assess the situation. “Historically, if a company wasn’t performing well and had issues with respect to liquidity and capital, auditors would have to say there’s substantial doubt you’re not going to be around for a year.” It fell to auditors to try to elicit disclosures from management, he says. “Now auditors can just point to the accounting literature.”
Evans says the standard is welcome also for its codification of a definition of “substantial doubt,” which is not defined in auditing standards. FASB says different interpretations of the term have led to different applications, another cause for diversity in practice. Some in the profession are debating whether having a clear definition of the term raises or lowers the bar from current practice in terms of when it would compel a disclosure, says Evans. “The debate is whether we’ll see more or less going concern emphasis in financial statements than we have today,” he says. “Most believe it will be probably less, but I don’t know that the bar has changed that much.”
With the standard now final, all companies need to study it and establish controls and processes for performing the evaluation each reporting period, says John Keyser a partner at McGladrey. “I would liken it to what we have now around subsequent events,” he says, where companies are required to consider events that have occurred after the close of a financial statement period but before financial statements are published and inform investors of any significant events or conditions they should consider.
“I don’t think it will have a lot of impact on the majority of companies,” says Keyser. “It clearly will impact companies that are struggling. In general companies are doing well and don’t have a lot of indications of substantial doubt, but every company will have to have internal controls around this.”
Smith agrees the analysis should be straightforward and not especially burdensome for companies that are clearly profitable and viable. “If a company is sitting on a pot of cash and going great guns, they will still have to at least consider whether there’s any sort of concern, but that would be a pretty quick exercise,” he says.