GOING CONCERN ACCOUNTING AND AUDITING ISSUES

By Larry L. Perry, CPA

CPA Firm Support Services, LLC

LEARNING OBJECTIVES

  • Understand the fundamental concepts of the going concern assumption.
  • Identify information contrary to the going concern assumption.
  • Understand managements’ and auditors’ responsibilities for detecting, disclosing and reporting on going concern issues.
  • Be able to prepare financial statements, footnotes and auditors’ and accountants’ reports when going concern problems are present.

INTRODUCTION—THE STATE OF THE STANDARDS

Preparing and reporting on entities with going concern issues is not new. During the 1970s, auditors became responsible for identifying and evaluating information contrary to the going concern assumption. Depending on the severity of the uncertainty, the reporting choice at that time was either a “subject to” opinion or a disclaimer of opinion.

In 1989, the Auditing Standards Board (ASB)issued Statement on Auditing Standards (SAS) No. 59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. When an auditor identified information contrary to the going concern assumption, he/she was required to obtain information about management’s plans to overcome the threats to continued existence and to evaluate the appropriateness and reasonableness of such plans and related footnote disclosures. This standard included an illustration of an explanatory audit report paragraph that should be used when substantial doubt exists about the entity’s ability to continue as a going concern. When such doubt existed, the standard stated that it was a departure from generally accepted accounting principles (GAAP).

In 2013, this statement was redrafted as SAS No. 126, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, with no change to practice. Depending on the severity of the threat to continued existence of the entity, an emphasis of matter paragraph, a qualified or disclaimer of opinion due to the uncertainty or an adverse opinion when the liquidation basis of accounting is required but not used.

In October 2008, the Financial Accounting Standards Board (FASB) issued an exposure draft of a proposed accounting standard,Going Concern, which was recently issued in 2014 as ASU 2014-15 (ASC Subtopic 205-40). This exposure draft requires management of reporting entities to identify and evaluate information contrary to the going concern assumption, develop a plan to overcome the threats to continued existence and disclose relevant information in footnotes to financial statements. Auditors are, under SAS No. 126, responsible for evaluating the appropriateness and reasonableness of management’s conclusions, disclosures and plans.

ACCOUNTING AND AUDITING STANDARDS IN THE UNITED STATES

ASU 2014-15, Going Concern (Subtopic 205-40)—Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern

Why Issued?

Under generally accepted accounting principles (GAAP), continuation of areporting entity as a going concern is the underlying premise for preparingfinancial statements unless and until the entity’s liquidation becomes imminent, when the liquidation basis of accounting is the appropriate financial reporting framework. Preparation of financial statements under this premise is called the going concern basis of accounting. Financial statements should be prepared under the liquidationbasis of accounting in accordance with Subtopic 205-30, Presentation ofFinancial Statements—Liquidation Basis of Accounting if and when an entity’s liquidationbecomes imminent

In circumstances when an entity’s liquidation is not imminent, there may be circumstances that raise substantial doubt about the entity’s ability to continue as a goingconcern. In those situations, financial statements should be preparedunder the going concern basis of accounting, with the amendments in this Update guiding the considerations for proper disclosures..

This Update provides guidance in GAAP about management’sresponsibility to evaluate whether there is substantial doubt about an entity’sability to continue as a going concern and to provide related footnote disclosures.

Major Provisions

Management has responsibility to assess the reportingentity’s ability to continue as a going concern. Financialstatements must be prepared on a going concern basis unless management either intends to liquidatethe entity or to discontinue operations, or in circumstances where liquidation or discontinuance are the only alternatives.

In assessing whether the going concern assumption is appropriate, management shalltake into account all available information about the future, which is at least, but is notlimited to, 12 months from the date financial statements are available for issue (for non-issuers) or issued (for issuers).When an entity has a history of profitable operations andready access to financial resources, management may conclude that the going concernbasis of accounting is appropriate without detailed analysis. When contrary information is present, managementmay need to consider a wide range of factors relating to current and future profitability,debt repayment requirements, and potential sources of replacement or additional financing to determine that the going concern basis is appropriate.

Management is responsible for identifying information about certain conditions or events that may indicate there could be substantial doubt about the reportingentity’s continued existence. The following are examples ofthose conditions and events:

  • Negative trends, for example, recurring operating losses, working capitaldeficiencies, negative cash flows from operating activities, and adverse keyfinancial ratios.
  • Other indications of possible financial difficulties, for example, default on loanorsimilar agreements, arrearages in dividends, denial of usual trade creditfrom suppliers, restructuring of debt, noncompliance with statutory capitalrequirements, and a need to seek new sources or methods of financing or todispose of substantial assets.
  • Internal matters, for example, work stoppages or other labor difficulties,substantial dependence on the success of a particular project, uneconomiclong-term commitments, and a need to significantly revise operations.
  • External matters that have occurred, for example, legal proceedings,legislation, or similar matters that might jeopardize an entity’s ability tooperate; loss of a key franchise, license, or patent; loss of a principal customeror supplier; and an uninsured orunderinsured catastrophe such as a drought,earthquake, or flood.

If management believes there is substantial doubt about the entity’s ability to continue as a going concern, management must develop appropriate and reasonable plans to overcome the identified threats to the entity’s continued existence. Management’s plans and considerations may include the following:

  • Plans to dispose of assets:
  • Restrictions on the disposal of assets, such as covenants limiting suchtransactions in loan or similar agreements or encumbrances againstassets.
  • Apparent marketability of assets that the entity plans to sell.
  • Possible direct or indirect effects of disposal of assets.
  • Plans to borrow money or restructure debt:
  • Availability of debt financing, including existing or committed creditarrangements, such as lines of credit or arrangements for factoringreceivables or sale-leaseback of assets.
  • Existing or committed arrangements to restructure or subordinate debtor to guarantee loans to the entity.
  • Possible effects on the entity’s borrowing plans of existing restrictionson additional borrowing or the sufficiency of available collateral.
  • Plans to reduce or delay expenditures:
  • Apparent feasibility of plans to reduce overhead or administrativeexpenditures, to postpone maintenance or research and developmentprojects, or to lease rather than purchase assets.
  • Possible direct or indirect effects of reduced or delayed expenditures.
  • Plans to increase ownership equity:
  • Apparent feasibility of plans to increase ownership equity, includingexisting or committed arrangements to raise additional capital.
  • Existing or committed arrangements to reduce current dividendrequirements or to accelerate cash distributions from affiliates or otherinvestors.

Disclosure:

When management identifies information that causes substantial doubt about the entity’s ability to continue as a going concern, footnotes to financial statements must disclose this information:

  • Pertinent conditions and events giving rise to the assessment of substantialdoubt about the entity’s ability to continue as a going concern.
  • The possible effects of those conditions and events.
  • Management’s evaluation of the significance of those conditions and eventsand any mitigating factors.
  • Possible discontinuance of operations.
  • Management’s plans to mitigate the effect of the uncertainties and whethermanagement’s plans alleviate the substantial doubt about its ability to continueas a going concern.
  • Information about the recoverability or classification of recorded assetamounts or the amounts or classification of liabilities.

When financial statements are not prepared on a going concern basis, the basis of preparation and the reasons why the entity is not regarded as a going concern must be disclosed in the footnotes.

AU-C 570 (SAS No. 126) The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern

This section of the AICPA Professional Standards contains guidance for auditors when evaluating whether there is substantial doubt about an entity's ability to continue as a going concern. An entity’s continuance asa going concern is assumed when no contrary information of significance can be identified. Information that significantly contradictsthe going concern assumption includes an entity's inability to meet its obligations without the sale ofassets, debt modification, changes in its operations, or other plans.

Responsibilities of Auditors

Auditors have a responsibility to evaluate whether there is substantialdoubt about the entity's ability to continue as a going concern for a reasonableperiod of time, not to exceed one year beyond the date of the financial statements. Practically speaking, however, auditors should also consider conditions and events that affect the going concern assumption which are identified by management and extend beyond the one year limitation. As stated above, ASU 2014-05 requires a look forward period of one year from the date financial statements are available for issue (non-issuers) or are issued (issuers).

The auditor’s objectives are to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, determine the possible financial statement effects and adequacy of disclosures regarding this uncertainty and determine the need for audit report modifications.

Auditors should evaluate whether there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time by following the guidance in AU-C 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement:

  • The auditor should consider whether the results of procedures performedin planning, gathering audit evidence relative to the various audit objectives,and completing the audit identify conditions and events that,when considered in the aggregate, indicate there could be substantialdoubt about the entity's ability to continue as a going concern for areasonable period of time. It may be necessary to obtain additionalinformation about such conditions and events, as well as the appropriateaudit evidence to support information that mitigates the auditor'sdoubt.
  • If the auditor believes there is substantial doubt about the entity'sability to continue as a going concern for a reasonable period of time,she/he should (1) obtain information about management's plans that areintended to mitigate the effect of such conditions or events, and (2)assess the likelihood that such plans can be effectively implemented.
  • After the auditor has evaluated management's plans, she/he concludeswhether there is substantial doubt about the entity's ability to continueas a going concern for a reasonable period of time. If the auditor concludesthere is substantial doubt, she/he should (1) consider the adequacyof disclosure about the entity's possible inability to continue as a goingconcern for a reasonable period of time, and (2) include an explanatoryparagraph (following the opinion paragraph) in the audit report to reflecthis conclusion. If the auditor concludes that substantial doubtdoes not exist, she/he should consider the need for disclosure.

Audit Procedures

Designing special procedures to detect information contrary to the going concern assumption usually is not necessary. The results of performing procedures in an audit plan (program) should be sufficient to identify and evaluate contrary information.

Auditing procedures that can reveal contrary information include:

  • Risk assessment procedures
  • Analytical procedures
  • Substantive tests of balances
  • Subsequent events reviews
  • Debt covenants reviews
  • Reading minutes of board and committee meetings
  • Obtaining lawyer’s letters

Identification and Evaluation of Contrary Information

Information contrary to the going concern assumption may be identified by auditors as a result of performing auditing procedures. The significance of such information depends on engagement circumstances. Conditions and events contrary to the going concern assumption from AU-C 570are similar to those from ASU 2014-15:

  • Negative trends—for example, recurring operating losses, working capitaldeficiencies, negative cash flows from operating activities, adversekey financial ratios.
  • Other indications of possible financial difficulties—for example, defaulton loan or similar agreements, arrearages in dividends, denialof usual trade credit from suppliers, restructuring of debt, noncompliancewith statutory capital requirements, need to seek new sources ormethods of financing or to dispose of substantial assets.
  • Internal matters—for example, work stoppages or other labor difficulties,substantial dependence on the success of a particular project,uneconomic long-term commitments, need to significantly revise operations.
  • External matters that have occurred—for example, legal proceedings,legislation, or similar matters that might jeopardize an entity's abilityto operate; loss of a key franchise, license, or patent; loss of a principalcustomer or supplier; uninsured or underinsured catastrophe such asa drought, earthquake, or flood.

Auditors’ Evaluation of Management’s Plans

Auditors should obtain information about management’s plans and evaluate their appropriateness and reasonableness. Management’s plans may be appropriate and reasonable if they are likely to mitigate the contrary information for a reasonableperiod of time and if such plans can be effectively implemented.

Section AU-C 570 states that auditors’ evaluation of management’s plans may include theses considerations:

  • Plans to dispose of assets.

—Restrictions on disposal of assets, such as covenants limitingsuch transactions in loan or similar agreements or encumbrancesagainst assets.

—Apparent marketability of assets that management plans to sell.

—Possible direct or indirect effects of disposal of assets.

  • Plans to borrow money or restructure debt.

—Availability of debt financing, including existing or committedcredit arrangements, such as lines of credit or arrangements forfactoring receivables or sale-leaseback of assets.

—Existing or committed arrangements to restructure or subordinatedebt or to guarantee loans to the entity.

—Possible effects on management's borrowing plans of existing restrictionson additional borrowing or the sufficiency of availablecollateral.

  • Plans to reduce or delay expenditures.

—Apparent feasibility of plans to reduce overhead or administrativeexpenditures, to postpone maintenance or research and developmentprojects, or to lease rather than purchase assets.

—Possible direct or indirect effects of reduced or delayed expenditures.

  • Plans to increase ownership equity.

—Apparent feasibility of plans to increase ownership equity, includingexisting or committed arrangements to raise additional capital.

— Existing or committed arrangements to reduce current dividend requirements or to accelerate cash distributions from affiliates orother investors.

When management’s plans are supported by prospective financial information, the auditor should consider the adequacy of support for significant assumptionsunderlying that information. The auditor's evaluation of such information should be based on knowledge of the entity and its environment and the qualifications of its management.

The evaluation should include:

  • Reading the prospectivefinancial information and underlying assumptions.
  • Comparingprospective financial information in prior periods with actual results and comparingprospective information for the current period with results achievedto date.

Beyond the requirements in Section AU-C 570, it may be necessary in some high risk situations to inspect the documentation supporting the prospective information. Marketing plans for new products, details of sales back orders, contracts and agreements for purchase and wage commitments, debt modification agreements and studies of market values of assets selected for disposition are examples of such documentation. In addition, the feasibility of management’s plans and the mathematical accuracy of related financial information should be evaluated.

Auditors’ Evaluation of Financial Statement Effects

After identifying and evaluating contrary information and concluding there is substantial doubt about the entity's ability to continue as a going concernfor a reasonable period of time, auditors must evaluatethe effects of this information on the financial statements and the adequacy of the footnote disclosures.

Section AU-C 570 indicates disclosures that may be necessary:

  • The conditions and events causing the substantialdoubt about the entity's ability to continue as a going concernfor a reasonable period of time.
  • The possible effects of such conditions and events.
  • Management's evaluation of the significance of those conditions andevents and any mitigating factors.
  • Possible discontinuance of operations.
  • Management's plans (including relevant prospective financial information).
  • Information about the recoverability or classification of recorded assetamounts or the amounts or classification of liabilities.

If management’s plans are sufficient to eliminate the substantial doubt about the entity’s continued existence, auditors should consider whether disclosure of the substantial doubt is necessary. Ordinarily, the threats to continued existence and management’s plans should be included in a footnote to answer questions of financial statement readers and to prevent the statements from being misleading.

Written Representations

When the auditor believes there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, the auditor should obtain written representations from management.These should include their plans to mitigate the adverse effects, the likelihood those plans can be implemented and that the financial statement disclosures include all relevant matters regarding the threats to continued existence and management’s plans.

Consideration of the Effects on the Auditor’s Report

If an auditor determines management’s plans are not appropriate and reasonable, and substantial doubt about continued existence remains, the auditreport should include an explanatory paragraph after the opinion paragraph to state that conclusion. Section AU-C 570 states “the auditor's conclusion about the entity'sability to continue as a going concern should be expressed through the use ofthe phrase ‘substantial doubt about its (the entity's) ability to continue as a going concern’ [or similar wording that includes the terms substantial doubtand going concern].

Depending on engagement facts and circumstances, auditors may elect to include an explanatory paragraph to emphasize and reference footnote disclosures and express an unqualified opinion, express a qualified opinion or issue an adverse opinion as described in AU-C Section 705, Modifications to the Opinion in the Independent Auditor’s Report.. Report examples are discussed later in these materials.