Going Concern Evaluations - Let’s Share the Fun

10/13/11

By David J. Bayens, CPA

In the depressed economic environment we have experienced over the past several years, the frequency of “going concern” warnings in auditors’ reports has increased dramatically. That doesn’t mean that everyone feels the auditors have done a good job of warning the public. There were many bankruptcies that took place without the auditors’ warnings in the financial statements that preceded the failures of these companies. Now FASB intends to make the going concern evaluation part of management’s job.

Some background

The “Going Concern” assumption is bedrock to current accounting principles. The balance sheet presentation of most assets is based on their original cost and liabilities based on the amounts at which they were incurred. Even financial instruments presented at fair values assume that the values are determined in the ordinary course of business in an orderly market. Unless there is some indication otherwise, it is assumed that a company will continue to exist into perpetuity. If the company is no longer a going concern, a liquidation basis of accounting must be used. As such, assets are stated at their liquidation value and liabilities at the amounts at which they will be liquidated.

Up until now the only accounting guidance that applied to going concern evaluations was in the auditing standards. As part of each audit, the auditor is required to assess whether substantial doubt exists about a company’s ability to exist as a going concern (i.e. the company will make it through the next year or so). Factors that an auditor should assess are both internal (ex: history of losses and factors necessary to return to profitable operations, adequacy of capital, and maturity dates of major debt obligations and the company’s ability to meet these deadlines) and external (ex: the financial health of the company’s customers and suppliers, and the availability of additional capital or financing if needed).

If the auditors’ assessment is that substantial doubt exists, an extra paragraph is added to the audit report indicating that the financial statements were prepared on a going concern basis and the fact that the financial statements don’t reflect any adjustments to assets or liabilities that might result if the company goes out of business. It also briefly describes the major problems the company is facing and often a reference to a footnote that describes management’s assessment of these problems and its plans to address them.

Not everyone is happy with the job the auditors have done. In ten of the major bankruptcies that took place during the latest economic downturn, the financial statements of only two of the companies had going concern language. Critics argue that a CPA firm realizes that issuing this type of opinion can seriously jeopardize its relationship with its client and avoids taking this step as much as possible.

What FASB will change

FASB would make it management’s duty to make the going concern assessment. A major reason for this is that management should have a more in depth understanding of the problems and potential solutions than the audit firm. The auditors are not absolved of their responsibilities; they still would have to test management’s analysis and, if necessary, include a going concern warning, even if management believes it is not necessary.

Financial statement disclosures required by FASB when a going concern situation exists include:

• Pertinent conditions and events giving rise to the assessment, including when such conditions and events are anticipated to occur, if reasonably estimable,
• The possible effects of those conditions and events
• Possible discontinuance of operations
• Management’s evaluation of the significance of those conditions and events and any mitigating factors
• Management’s plans to mitigate the effects of the conditions and events, whether those plans can be effectively implemented, and the likelihood that such plans will mitigate the adverse effects
• Information about the recoverability or classification of recorded asset amounts and or the amounts or classification of liabilities.

FASB anticipates issuing an exposure draft on these matters during the first half of 2012.