Can slight differences in the wording of going concern standards affect the extent of audit tests performed and the decisions that auditors make? The authors seek to answer that question via an experiment: auditors were given the same information for a going concern assessment, but different criteria for the evaluation based upon current U.S. and international standards. The results show that differences in wording do matter—both in terms of the information auditors believe they would need to make their assessments and in terms of the conclusions they would reach.
The guidance on determining whether an entity is a going concern has long been located in the auditing literature; but, with the recent issuance of FASB’s Auditing Standards Update (ASU) 2014-15, Presentation of Financial Statements—Going Concern: Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, considerations now exist within the accounting literature as well. Given that guidance also exists in the international realm, debate has arisen about whether subtle differences in the wording of standards affect auditors’ decisions. Could seemingly minor variances in terminology result in unexpected disparities in the extent of audit tests performed—and going concern conclusions reached—by auditors?
To answer this question, the authors asked currently practicing audit partners and managers to participate in an experiment that held information relevant to a going concern assessment constant, while varying the wording of the criteria for a going concern evaluation based upon current and proposed terminologies. The results show that wording differences do matter—both in terms of the information auditors believe they would need to make their assessments (ergo, the work required) and in terms of the conclusions they would reach.
The following provides a brief background of the going concern issue and presents the results of the survey. Based on the results, the authors discuss the implications of ASU 2014-15 and the PCAOB’s recently issued Staff Audit Practice Alert 13, “Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern.”
Prior to FASB’s issuance of ASU 2014-15 in August 2014, guidance in the United States related to going concern uncertainties was contained only in the auditing standards. The relevant standards for audits of public and nonpublic companies are essentially the same in substance, though the codifications differ. The governing standard for audits of nonpublic companies is AU-C section 570, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern,” which clarified and replaced AU section 341, a standard with substantially the same criteria. The PCAOB has not adopted the AICPA’s clarified reference system; thus, AU section 341 remains applicable to audits of U.S. publicly traded companies. Applicable to auditors as well, it proscribes, “The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’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, hereinafter referred to as, ‘a reasonable period of time’” [emphasis added].
Internationally, going concern evaluations are proscribed in both the accounting and auditing literature. The IASB’s International Accounting Standard (IAS) 1, Presentation of Financial Statements, specifies a going concern time frame of at least but not limited to 12 months from the end of the reporting period. The International Auditing and Assurance Standards Board’s (IAASB) ISA section 570 (paras. 10–14) uses a foreseeable future time frame that, based on guidance, is at least but not limited to 12 months from the end of the financial statement date.
The stated purpose of FASB’s initial exposure draft for ASU 2014-15 was, among other things, to address the lack of guidance in U.S. accounting standards, the diversity in disclosure of going concern uncertainties, and the differences between U.S. and international accounting standards. It proposed that management use a time frame for going concern evaluation consistent with that of IAS 1. Many constituents took exception to the proposed time frame and FASB’s stated belief that a change in the time frame would not lead to changes in practice. (See FASB’s comment letter summary at http://bit.ly/1NrAZX0.) For example, Deloitte and Touche LLP commented that “contrary to the Board’s comments in the Basis for Conclusions of the proposed Statement, we believe that the guidance in the proposed Statement on the (1) open-ended time horizon, (2) information to be considered, and (3) interim assessments will significantly change practice both for management and an entity’s auditors [emphasis in original]” (http://bit.ly/1QPzq7r).
As a result, the going concern criteria in ASU 2014-15 are less aligned with IAS 1 than when first proposed. Specifically, if conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, ASU 2014-15 requires financial statement disclosure of 1) conditions or events that give rise to the possibility of going concern issues, 2) management’s evaluation of the possibility, and 3) management’s plans to mitigate the possibility. An important difference between the new accounting rule and the current U.S. auditing standards lies in the definition of “substantial doubt.” Whereas AU section 341 does not include a threshold (e.g., probable) or specific definition, ASU 2014-15 states:
Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the aggregate, indicate that it is probable [emphasis added] that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.
Yet another subtle difference between ASU 2014-15 and AU section 341 is the look-forward period. ASU 2014-15 specifies that management must assess the ability of the entity to continue as a going concern for a period of one year “from the date that the financial statements are issued,” whereas AU section 341 specifies a period of one year “beyond the date of the financial statements being audited.”
Less than one month after the issuance of ASU 2014-15, the PCAOB issued Staff Audit Practice Alert 13, reminding auditors of publicly traded companies that, regardless of whether ASU 2014-15 results in disclosure of going concern information in the financial statements, auditors must still follow the requirements of AU section 341 when making their going concern evaluations.
The above-described differences between criteria in ASU 2014-15 and both U.S. auditing and international accounting and auditing literature are summarized in Exhibit 1.
Comparison of ASU 2014-15 Criteria to U.S. Auditing and International Accounting and Auditing Criteria
To provide evidence of the practical impact—if any—of wording differences in going concern criteria, the authors solicited approximately 200 currently practicing audit partners and managers to participate in an experiment. Of those, 90 (45%) agreed to take part; the majority were audit partners or principals (47), or senior managers (35), in international accounting firms. Of the 90 responses, 84 were usable in the study’s analyses. Six participants reported being “not at all familiar” with going concern opinion modifications; thus, their responses were excluded.
Holding the situational and financial information of a hypothetical company constant, the survey first asked auditors, “Which of the following are the three most important items critical to your assessment [emphasis in original],” using the following four criteria:
- For a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited
- Considering all available information about the future, for at least but not limited to 12 months from the end of the reporting period
- For the foreseeable future, defined as generally but not limited to 12 months from the end of the reporting period
- For the foreseeable future.
Exhibit 2 summarizes the frequency of information (projected income statements, cash flows, and balance sheets) selected as most important for evaluation. The top three choices for each of the four criteria are highlighted.
Frequency of Information Selected as Necessary
As depicted, as the time frame becomes increasingly less finite, the information required to make a going concern conclusion increases. The type of information selected by participants as being critical to their going concern evaluations is least forward-looking (limited to a single year of projections) under the “not to exceed one year” criteria (criterion 1), and it is greatest (includes three-year projections) under the “foreseeable future” criteria (criterion 4). Also evident from the data are participants’ shifts away from a balance sheet emphasis as the time horizon becomes less definitive—moving away from criterion 1 and toward criterion 4.
For the next part of the experiment, participants were provided with a scenario, held constant for each of the four experimental criteria. They were asked to answer the following using a Likert scale (1 = very unlikely, 4 = undecided, 7 = very likely): “Based solely on the criteria and information provided, evaluate the likelihood that your audit report will be modified for going concern uncertainties.” In effect, this controls for differences found to impact auditors’ going concern decisions, including auditee-specific characteristics and circumstances, such as client pressures, as well as auditor-specific characteristics. It also controls for the framing of information pertinent to the auditor’s going concern decision, which has also been found to influence the propensity to issue an opinion modification (see Priscilla O’Clock and Kevin Devine, “An Investigation of Framing and Firm Size on the Auditor’s Going Concern Decision,” Accounting and Business Research, vol. 25, no. 9, pp. 197–207).
The results suggest that that the likelihood of issuing a going concern opinion increases monotonically as the time frame becomes less finite. Under criterion 1 (“not to exceed one year”), participants were unlikely to issue an opinion modified for going concern uncertainties (average response, 3.40), whereas under criterion 4 (“foreseeable future”), participants were divided on whether to issue a going concern modification (mean response, 4.03)—all statistically significant differences. These results were not affected by the experience of the auditors or by the size of their firms.
Beyond variations in the time frame, terminology differences also exist in the “hurdle” for going concern assessments. AU section 341 uses “substantial doubt,” while IAS 1 uses “significant doubt,” both of which have been criticized by the PCAOB’s Investor Advisory Group as being artificially high hurdles (http://bit.ly/1Rrl8eM). ASU 2015-14 arguably raises the bar by specifying that substantial doubt exists only when it is probable that the entity will not be able to meet its obligations.
To see how practicing auditors view the threshold for making going concern assessments, the authors asked participants to quantify the levels of uncertainty they believe constitutes “substantial doubt” and “significant doubt.” Participants could choose any number on a scale from 1 to 100, where 1 represents no doubt about that an entity will continue as a going concern, and 100 represents absolute certainty that an entity will fail to continue as a going concern. Of the original 90 participants, 67 responded to both of these questions. On average, participants reported 67% as the level of uncertainty required to issue a going concern opinion modification using the “substantial doubt” terminology, and 60% as the level of uncertainty required using the “significant doubt” terminology. This suggests that auditors may be less likely to modify their opinions for going concern under AU section 41 than under IAS 1. In addition, 70% (87%) of participants believe the threshold for substantial doubt (significant doubt) is met when their uncertainty about the ability of the entity to continue as a going concern is 75% or less.
The results provide evidence that differences in the wording of going concern criteria elicit different practice outcomes. The likelihood of issuing a going concern opinion increases monotonically as the time frame the auditors must use to make their decisions becomes more uncertain. Furthermore, 70% of the practicing audit partners and managers surveyed believe that the “substantial doubt” threshold for uncertainty used in ASU 2015-14 and AU section 341 is 75% or less.
The introduction of ASU 2015-14 to the accounting literature requires management to evaluate an entity’s ability to continue as a going concern. Management must consider whether it is “probable” that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. This is an important departure from AU section 341, which not only omits a definition of substantial doubt, but also states, “The auditor is not responsible for predicting future conditions or events.” As such, auditors could end up in the curious position of concluding that a going concern opinion modification is warranted—while management concludes that the financial statements require no going concern disclosure because ASU 2014-15’s “probable” hurdle has not been met. It is interesting to note that webcast commentary of several of the largest accounting firms discussing ASU 2014-15 vary dramatically in their views about the threshold for the term “probable.” One suggests that “probable” is 80%, while another suggests that it is 60% to 70%.
On the other hand, if auditors informally adopt the “probable” threshold—to be consistent with accounting standards—for determining substantial doubt, the number of opinions modified for going concern might decline. This might, in part, explain why the PCAOB was so prompt in issuing its Staff Audit Practice Alert 13. It reminds auditors of publicly traded companies that they must follow AU section 341, even if management’s going concern conclusion under ASU 2015-14 differs from their own conclusion.
The introduction of ASU 2015-14 to the accounting literature requires management to evaluate an entity’s ability to continue as a going concern.
Prior research suggests that auditors’ accuracy rates for issuing going concern opinions in the year prior to bankruptcy have ranged from 40% to 54%. (See Elizabeth K. Venuti, “The Going-Concern Assumption Revisited: Assessing a Company’s Future Viability,” The CPA Journal, May 2004, pp. 40–43.) That is, roughly half of all companies that go bankrupt did not receive a going concern opinion in the prior year. If auditors interpret the criteria in ASU 2014-15 as creating a higher threshold for going concern disclosures and opinion modifications, the number of these “false negatives” might rise. False negatives can be costly to auditors, damaging their reputations and increasing the risk of litigation from investors and creditors. On the other hand, issuing a going concern opinion on the financial statements of an entity that does not fail within one year can also be costly. These “false positives” could lead to a self-fulfilling prophecy in which financiers and vendors are reticent to extend credit, worsening a company’s financial position and possibly precipitating (or accelerating) failure. A higher threshold for going concern opinions could mean fewer false positives. Considerable care must be taken as auditors strive to comply with accounting and auditing standards while protecting their reputations for opinion accuracy.
Professor Dee commenced work on this paper in her personal capacity prior to beginning her fellowship with the PCAOB. The paper represents her views and does not necessarily represent the views of the board, members of the board, or other staff of the PCAOB.