External financial statements are prepared on the assumption that the company is a going concern—the company 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 If the going concern assumption is no longer valid, the company’s assets and liabilities should be reported at the amounts estimated to be collected or paid when they are liquidated. What is or should be the role of external auditors in reporting client (company)’s going concern status? How evaluation of going concern status is conducted? How to evaluate auditor’s going concern report? Follow on…
The Roles of Auditors in Evaluating and Reporting Company’s Going Concern Status
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.
In the U.S., the going concern question was formally addressed 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 reafcompanyed 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.
Evaluating 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 – For example, recurring operating losses, working capital deficiencies, negative cash flow from operating activities, adverse key financial ratios.
- Indicators of Possible Financial Difficulties – For example, 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 – For example, 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 – For example, 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 and SAS 59
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 company 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.
Evaluating Auditor’s Going Concern Report
Does the auditor’s going concern report convey useful information? Four lines of research have addressed this question:
1. 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.
2. 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.
3. 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.
4. 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.