External financial statements are prepared on the assumption that the firm is a going concern; i.e., that it will continue to operate indefinitely. Based on this assumption, assets are generally recorded at cost and depreciated over their expected useful lives. If the going concern assumption is no longer valid, the company’s assets and liabilities should be reported at the amounts estimated to be collected or paid when they are liquidated. Going concern evaluations have been top-of-mind for the audit profession. This comes as auditors walk away from year-end reviews and the public digests the prominence of certain going-concern doubts. For instance: General Motor’s admission recently that its auditor, Deloitte & Touche, couldn’t foresee the automaker being able to last the year because of GM’s enormous recurring losses, stockholder deficit, and inability to keep cash.
What is or should be the role of external auditors in evaluating and reporting on a company’s going concern status? What’s the most recent updates on auditor’s “going concern ”? What should client’s do in concerning the “going concern qualification?“ What are regulators up to the going concern rule? Through this post I am going to discuss this topic; from the historical to the most recent update. Enjoy!
Historical Roles Of Auditors and The Going Concern Assumption
Historically, the auditor’s role in reporting on financial statements has been restricted to an assessment of fair presentation of financial position and results of operations. While management is responsible for reporting on the entity’s financial position and results of operation, the auditor’s role is to evaluate management’s assertions and issue a report on the fairness of the financial statements. Current and future investors make decisions on the company’s prospects for survival using the financial statements and other available information.
Over the years, however, the public has perceived the auditor’s role in a somewhat larger context one that also encompasses an assessment of a company’s viability. The perception is best reflected by the cries of “where were the auditors?” when a company suffers a financial collapse shortly after receiving an unqualified audit opinion on its financial statements. This expectation gap has been the source of much debate.
The historical role of auditors is predicated on the premise that, in the absence of clear evidence to the contrary, auditors should assume their clients will continue in existence. Continuity is a necessary postulate whose abandonment makes auditing improbable, if not impossible. Moreover, the postulate places an important limit on the extent of an auditor’s responsibilities and provides a basis for reducing the extent of his obligation to forecast the future and to have his work judged on the basis of hindsight.
Over the years, this historical role was challenged on three grounds:
- First, auditors have access to information not generally available to financial statement users.
- Second, some auditors and financial statement users believe that issuance of a modified opinion may provide auditors protection from lawsuits.
- Third, the option of a modified opinion provides the auditor with leverage to force disclosures about the continuity of the company that might not otherwise be forthcoming from management.
The going concern question was formally addressed in the USA by the Commission on Auditors’ Responsibilities (CAR), an independent study group commissioned in 1978 by the board of directors of the American Institute of Certified Public Accountants (AICPA) to develop recommendations regarding the appropriate responsibilities of independent auditors. CAR concluded that the going concern report was confusing to users, detracted from the functions of the auditor, and often created false expectations among users. In CAR’s view, uncertainty about a company’s ability to continue in operation is more effectively communicated by a disclosure in, or an adjustment of, the financial statements rather than through any audit reporting requirements.
The Auditing Standard Board (ASB) subsequently reaffirmed CAR’s conclusions. However, user opposition that greeted the draft proposal was instrumental in the deferral of formal action. As the incidence of corporate failures escalated in the 1980s, legislators raised additional questions about the auditor’s limited role in signaling early warnings about the possibility of business failure.
Faced with various pressures, the ASB issued Statement of Auditing Standard (SAS) No. 59 in 1988. SAS No. 59 requires the auditor to evaluate whether there is substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited. If the auditor has substantial doubt about the entity’s ability to continue in existence for that length of time, the auditor should add an explanatory paragraph highlighting the client’s disclosure of the going concern uncertainty to the standard unqualified report.
Evaluation of Client’s “Going Concern” Status
Statement of Auditing Standard (SAS) No. 59 provides guidance to auditors on how to evaluate a client’s viability status. The auditor must assess the client’s ability to meet its obligations as they become due without having to liquidate its assets, restructure debt, be forced by outsiders to revise its operations, or other similar actions.
Conditions or events that raise doubts about the client’s ability to continue in existence include:
- Negative trends e.g., recurring operating losses, working capital deficiencies, negative cash flow from operating activities, adverse key financial ratios.
- Indicators of possible financial difficulties e.g., default on loan or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, non-compliance with statutory capital requirements, need to seek new sources or methods of financing or to dispose of substantial assets.
- Internal matters e.g., work stoppages or other labor difficulties, substantial dependence on the success of particular projects, uneconomic long-term commitments, or need to significantly revise operations.
- External matters e.g., legal proceedings, legislation, or similar matters that might jeopardize an entity’s ability to operate; loss of key franchise, license, or patent; loss of a principal customer or supplier; or uninsured or underinsured catastrophe such as a drought, earthquake or flood.
If the aggregate effect of these conditions and events suggest that the client may have continuity problems, the auditor must consider and evaluate the feasibility of management’s plans for dealing with these adverse effects. Management plans include:
- plans to dispose of assets and the effects of such disposals;
- plans to borrow money or restructure debt and the effects of such plans on existing covenants;
- plans to reduce or delay expenditure and the effects of such delayed expenditure on operations; and
- plans to increase ownership equity.
If substantial doubt about the entity’s ability to continue as a going concern remains, the auditor’s report must include an explanatory paragraph with the audit opinion that comments on the going concern uncertainty.
Research evidence suggests auditors do follow the guidance in SAS 59. There is also evidence that the going concern decision involves economic tradeoffs of the risks of losing a client, of being exposed to third party lawsuits, and of loss of reputation.
The typical research study examines a client’s bankruptcy status subsequent to receiving a going concern report. In effect, the researcher uses the benefit of hindsight to compute auditors’ hit rate. As a benchmark, the hit rate of a bankruptcy model, proposed by the researcher, is compared to auditors’ hit rate. Research studies generally confirm that ex-post models outperform auditors in predicting bankruptcy. However, since going concern decisions are not equivalent to predicting bankruptcy, these studies do not unambiguously resolve the question of how well auditors evaluate their clients’ continuity status.
Evaluation of the Going Concern Report
Does the auditor’s going concern report convey useful information? Four lines of research have addressed this question:
. Information Content Studies
The typical study in this paradigm examines a company’s stock price reaction to an auditor’s going concern announcement. A company’s prior stock market returns (together with the market rate of returns) are used to develop an expectation of future returns. This expected return is compared to the actual return around the time of an issuance of a going concern report. If the actual return varies significantly from the expected return, an inference is drawn that the auditor’s announcement conveyed additional information to the market. On the other hand, if the actual return does not differ significantly from the expected return, the auditor’s report is considered as not providing useful information to investors.
Research results using this approach have been mixed. Further, to use this paradigm effectively, a researcher must be able to precisely identify the audit report announcement date and ensure that no other concurrent information is released around the announcement date. Both requirements are difficult to overcome.
. Publicly Available Information Studies
Studies in this paradigm examine the association between publicly available information and the going concern report. If market participants are able to use readily available public information to predict the issuance of a going concern report, the subsequent release of the report should not convey new information to the market.
Various models using financial statement ratios and stock market variables have been developed that predict the going concern report very accurately. Taken together, these studies suggest that the going concern report provides redundant information.
. Survey Studies
Survey studies involve direct inquiry of investors to ascertain their views on the usefulness of the going concern report. Such studies consistently indicate that investors consider going concern reports to be useful. Further, investors believe that the issuance of a going concern report should enhance the defensive posture of the auditor in the event of a lawsuit.
. Experimental Studies
Experimental studies place users in simulated decision-making contexts and examine users’ decisions with and without a going concern report. The studies indicate that as long as the going concern uncertainty is disclosed in a footnote to the financial statements, the going concern report is redundant.
Growing Concerns over “Going Concern” Qualification [2008-2009]
Audit firms issued 19 percent more going-concern opinions last year, according to data compiled by Audit Analytics that was cited by the PCAOB in a memo to its advisers. As of mid-March, more than 23 percent of filings of public-company filings made for fiscal year-ends from June 30, 2008, to December 31, 2008 included a going-concern opinion.
Many companies are in this situation today. Last year, 21% of companies registered with the Securities and Exchange Commission had their going-concern status questioned — the highest proportion of companies this decade, according to research firm Audit Analytics. Moreover, the number of businesses filing for Chapter 11 increased 113% in the first half of this year, compared to the same period in 2008.
Experts predict a similar percentage of going-concern opinions will be filed for 2009 10-Ks. Indeed, the prospect has finance executives biting their nails. Nearly one quarter of 846 CFOs and controllers surveyed by Grant Thornton said they were more worried about the ability of their companies to continue as a going concern than they were a year ago.
In what may have been a gross understatement, General Motors CFO Ray Young summarized 2008 as “a tough year” in a conference call with investors recently. And GM’s future certainly didn’t look any brighter today, as Deloitte & Touche expressed its doubts that its carmaker-client will stay viable.
In the GM annual report filed, the company carried the auditor opinion that GM had warned previously would be coming. “The corporation’s recurring losses from operations, stockholders’ deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern,” wrote Deloitte.
General Motors, though, is only one of the more prominent potential casualties of the credit crisis and recession to be in danger of getting a going-concern qualification stamped on its year-end financial filings. Indeed, just as stakeholders have become evermore preoccupied with the words “liquidity” and “cash flow,” they have also begun to keep a sharper eye on their companie’s ability to continue as a going concern.
Surely, the auto industry will see an uptick in going-concern doubts, but other sectors could get stuck with more of the qualifications as well. Homebuilders, financial services firms, and retailers are particularly hurt by financial crisis. And companies in other industries with heavy debt loads may also have to go through their auditors’ going-concern wringer.
As a result, there have been more uncomfortable conversations between companies and their auditors. And those discussions likely will become lengthier and more intense as both parties work their way through new accounting guidelines that call on management to look out further than their auditors when assessing their companies’ sustainability. The new rules — which the Financial Accounting Standards Board plans to release by the end of this month for filing periods ending after June 15, 2009 — could lead to “a direct and very public disagreement over going concern between auditor and management”, the Ohio Society of CPAs predicted in a letter to FASB.
How Should Auditors and Companies Concerning “Going Concern”?
Current auditing rules still and [even more] require auditors to consider several factors during their reviews that may tip them off to the prospect that a company won’t be in existence by the next time they do their next annual review. Among them: negative recurring operating losses, working capital deficiencies, loan defaults, unlikely prospects for more financing, and work stoppages. Auditors also consider external issues, like legal proceedings and the loss of a key customer or supplier.
Auditors are increasingly expecting companies to do self-assessments of their going-concern risk before they’ll reach their own conclusion. Auditors have a higher expectation that management will assume greater responsibility for the going-concern risk assessment process.
Standard-setters have a similar expectation: Next month, the Financial Accounting Standards Board will revisit a proposed rule that would formalize management’s responsibility when it comes to considering a company’s going-concern status. While companies opine on their viability in annual reports, there is currently no accounting rule that governs how they do so.
The new FASB rule tells management to look ahead at least 12 months when assessing their company’s viability. But the current auditing standards tell the firms to keep their assessments to under a year from when they review a company’s financial statements. The discrepancy didn’t sit well with critics of FASB’s proposal, including the audit firms. “To expect management to make judgments about conditions and events that may exist or occur 18 or 24 months from now, or even later, may be unrealistic and impracticable,” Deloitte wrote.
The standard-setters will revisit whether the auditing standards need to change because of the time-horizon difference. “If the FASB establishes a time frame that is different than what auditors currently are required to consider, it is important that we take another look at the auditor’s responsibility,” says Ray. He added that, while it might not be necessary for an auditor to evaluate the same time period management is required to assess, the PCAOB likely will consider how well investors will understand any such difference.
For now, FASB plans to stick to the 12-months-plus guideline, which doesn’t please finance executives who will have to expand their outlook.
If there’s potential doubt about a company’s going-concern status, the audit firm is expected to talk to management about how they plan to keep the company afloat — such as by selling off noncritical assets — and the feasibility of such plans. If, after assessing management’s strategies, the auditors still have “substantial doubt” about the company’s ability to stay a going concern, they will explain that in their report. Otherwise, without a going-concern qualification, auditors “presume you will stay in business,”.
Through one of its rare practice alerts in December, the Public Company Accounting Oversight Board warned the audit firms to pay attention to high-risk areas for fraud and mistakes during their reviews of financial statements prepared amid the financial downturn. Among the board’s reminders was the particular challenge some companies may face to remain viable during a time when many companies’ access to financing has decreased and the number of delayed payments has increased.
To be sure, a going-concern qualification doesn’t always mean the end — through bankruptcy court or liquidation — is imminent. But it does portend a yearlong battle for the CFOs at the finance helm of these companies. They are tasked with reassuring creditors and business partners that, with the forebearance of their counterparties, they will survive and eventually prosper.
Accounting experts recommend companies consider looking at their going-concern status now, even if they’re only at the half-way mark of their reporting year (most companies’ annual reports aren’t due until early next year).
What Are Regulators Up to the “Going Concern” Rules?
It’s the one area of financial reporting where auditors are required to play forecaster. Here, they must go beyond their more comfortable role of reviewer where they retrospectively look over a company’s past financial performance. What’s more, the prediction portion of their jobs is getting harder. That’s because the current downturn has poked holes in previously settled auditing assumptions and the capital structures of previously well-financed companies.
Recently, the PCAOB asked its advisory group for input on how to change its rule to make it more like FASB’s. Although FASB based some of its yet-to-be-issued guidelines on the PCAOB’s rule, the accounting standard-setter requires management to look out further into the future than their auditors must. The auditor regulator has been waiting for FASB’s final standard before adjusting its own rule — a concept that doesn’t sit well with some of the advisory group members, who don’t want to be restricted by the language FASB uses.
Several of them requested that the PCAOB ask FASB to hold off on issuing its new rule so that the PCAOB could revisit its standards without being restricted by the FASB’s text.
Scheduled to be released later this month for financial periods ending on or after mid-June 2009, the new FASB rule will tell management to look ahead at least 12 months when assessing their company’s viability. But the current auditing standards tell auditors to keep their assessments to under a year from when they review a company’s financial statements.
The PCAOB also warned auditors last fall that companies’ abilities to stay viable during the downturn would likely slide. Auditors, in addition, have been accused of not raising going-concern red flags for investors before companies have filed for bankruptcy protection. Past academic studies have found audit firms have made going concern qualifications for just over half of the companies that go bankrupt according to Joseph Carcello, a University of Tennessee professor who sits on the PCAOB’s advisory group.