Historically, auditors of financial statements have been charged with the assessment of an entity’s ability to continue as a going concern (see AU 341, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern”). But nowhere in U.S. GAAP was management specifically charged with this responsibility, even though management has overall responsibility for the financial statements. Some would assert that encumbering the auditor with primary responsibility for monitoring going concern creates a serious lack of auditor independence, because the auditor is charged with assuming a management-type responsibility. This is about to change.
In August 2014, FASB released ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern [Accounting Standards Codification (ASC) 205-40]. This new standard specifically requires management to evaluate going concern and make disclosures in the notes to the financial statements when appropriate. The auditor will, in turn, audit management’s disclosures.
This article covers the major provisions of this new standard, which will be effective for fiscal years (and interim periods) ending after December 15, 2016, with early application permitted. ASU 2014-15 does not replace existing auditing guidance on going concern. Moreover, the new accounting standard is not totally aligned with the existing auditing standards, and the independent auditor must address whether it is appropriate to add an emphasis paragraph to the audit report regarding going concern. The PCAOB and the AICPA Auditing Standards Board (ASB) both have projects on their agendas that have the potential to address disclosure differences and related auditor report issues before the effective date. This article highlights several major differences between the accounting standard and existing auditing guidance.
Overview of ASU 2014-15
ASU 2014-15 includes a decision flowchart that provides a high-level overview of amendments to the ASC made by the new guidance on going concern. As indicated earlier, this standard provides guidance to management—not auditors.
The initial step in the process is for management to ensure that the entity is not operating within the scope of ASU 2013-07, Presentation of Financial Statements: Liquidation Basis of Accounting. Per ASU 2013-07, once liquidation is deemed “imminent,” an entity must adopt the liquidation basis of accounting. An entity would be operating within the scope of ASU 2013-07, for example, if a plan of liquidation has already been approved by the board of directors of the entity and the probability is remote that the entity will return from liquidation. Hence, once an entity has adopted the liquidation basis of accounting, going concern is no longer at issue.
Assuming that liquidation is not imminent, ASU 2014-15 mandates that management ask whether there are conditions or events, considered in the aggregate, that raise “substantial doubt” about the entity’s ability to continue as a going concern within one year after the date financial statements are issued. An affirmative answer to this question triggers the requirement for disclosures. The specific disclosures needed are a function of whether management’s plans to mitigate the conditions or events that raise substantial doubt will alleviate substantial doubt. Management must ask two questions concerning their plans:
- Is it probable that plans will be effectively implemented within the assessment period?
- Is it probable that plans will mitigate the relevant conditions or events that raise substantial doubt within the assessment period?
This new standard specifically requires management to evaluate going concern and make disclosures in the notes to the financial statements when appropriate. The auditor will, in turn, audit management’s disclosures.
An affirmative answer to both of these questions with an overall assessment that substantial doubt is alleviated would require management to provide note disclosure of the challenges the entity faced before consideration of management’s plans, their evaluation of the significance of said challenges, and their plans that alleviate substantial doubt. The lack of an affirmative response to one or both of these questions will necessitate disclosures concerning challenges the entity faces, the significance of said challenges, and management’s plans intended to mitigate the challenges. More importantly, an explicit disclosure that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued will be required.
The Initial ‘Substantial Doubt’ Determination
ASU 2014-15 adds the term and definition of “Substantial Doubt about an Entity’s Ability to Continue as a Going Concern” to the ASC. The definition reads as follows:
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 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 (or within one year after the date that the financial statements are available to be issued when applicable). The term probable is used consistently with its use in Topic 450 on contingencies.
It is important to note the following regarding the initial assessment:
- The substantial doubt determination concerns the entity’s likely inability to meet its obligations.
- “Probable” is used in the definition to indicate “likely to occur.”
- Because management is already responsible for disclosing important events and circumstances occurring after the balance sheet date, but before financial statements are issued (the subsequent events period), FASB decided to make the assessment period one year after the date the financial statements are issued. As discussed further below, this provides a going concern assessment that extends farther into the future—that is, the subsequent events period plus the one-year look-forward period—than is currently provided by auditing standards.
- The definition includes “available to be issued” to cover nonpublic entities that may not officially issue financial statements but are covered by the standard. As indicated earlier, the going concern assessment applies to each annual and interim reporting period.
In the basis for conclusions of ASU 2014-15, FASB acknowledged that the substantial doubt determination involves a significant degree of judgment—qualitative and quantitative information should be considered regarding conditions and events “known and reasonably knowable.” Amendments to the ASC contain several examples of items to consider in determining whether substantial doubt exists. Examples include the entity’s current financial conditions, obligations due or anticipated, funds necessary to maintain the entity’s operations, regulatory issues, legal issues, natural disasters, and workforce issues.
Equally important, in its background information and basis for conclusions, FASB indicates that an extensive analysis concerning going concern may not be necessary at the end of each period for every entity. This may be applicable, for example, when an entity has a history of profitable operations and cash flow from operations, existing resources that are more than adequate to meet obligations, and known access to financial resources if needed. On the other hand, an entity with a long history of operating losses and negative cash flow from operations, a liquidity deficiency, and signs that indicate that it would be difficult to acquire additional resources would likely need an extensive analysis addressing going concern. Entity-specific facts and circumstances must be considered in deciding the level of analysis necessary.
Management’s Plans and Substantial Doubt
As indicated earlier, when an initial assessment indicates that substantial doubt exists, management plans, if any, must be considered to determine the specific disclosures necessary. These plans should be considered only after they have been fully implemented at the financial statement issuance date. Arguably, management has the best knowledge of conditions and events giving rise to substantial doubt and whether their plans alleviate substantial doubt or only mitigate substantial doubt. Our earlier overview lists the disclosures necessary in each case.
The implementation guidelines and illustrations of ASU 2014-15 provide examples of plans that management may have implemented to address substantial doubt. Examples include plans to dispose of assets, borrow money or restructure debt, reduce or delay expenditures, and increase ownership equity. The standard also addresses some of the issues that must be raised in evaluating the feasibility of said plans. For example, assume that management’s sole plan is to dispose of assets. Several questions must be addressed. Are there restrictions on disposal of said assets? Are the assets not marketable? Will the disposal have a negative effect on the business? An affirmative answer to these questions might suggest that substantial doubt is not mitigated, nor is it alleviated. On the other hand, assume that the asset is an investment in a subsidiary and it is probable that the business can be sold. Further analysis of the potential transaction could alleviate substantial doubt. Again, a significant amount of judgment may be necessary to assess management’s plans and the implications for mitigating or alleviating substantial doubt.
Accounting Standards versus Auditing Standards
For decades, auditors have evaluated going concern and the need for related disclosures and audit report modification, as mandated by the PCAOB’s AU 341 and the AICPA’s AU-C 570. FASB took a bold step forward with ASU 2014-15. Though the existing auditing guidance is the basis for the new accounting guidance, there are a few key differences, summarized in the Exhibit.
ASU 2014-15 versus Auditing Guidance (PCAOB AU 341 and AICPA AU-C 570)
First, ASU 2014-15 defines substantial doubt and includes a “probable” (likely) threshold in the definition. Auditing guidance provides sample indicators of substantial doubt but does not provide a definition. FASB defined substantial doubt to reduce the subjectivity in its interpretation that may be inherent in the auditing guidance. Second, ASU 2014-15 requires that management assess substantial doubt both annually and each interim reporting period. The auditing guidance generally provides for an annual assessment. Thus, ASU 2014-15 mandates a rolling assessment to provide more relevant information for those entities that issue interim financial statements or have them available to be issued. Third, while both the accounting and auditing standards provide for one-year look-forward periods, they use different anchors. ASU 2014-15 uses one year from the date that the financial statements are issued or available to be issued as its anchor. Auditing standards use one year from the balance sheet date as the anchor. ASU 2014-15 is written to provide a more relevant going concern assessment.
Filling the ‘GAAP’
ASU 2014-15 represents a major step in the right direction for the accounting profession. Management—not the independent auditor—has primary responsibility for the financial statements. Thus, management should have primary responsibility for addressing going concern, and the independent auditor should audit management’s assessment. ASU 2014-15 establishes the “accounting rules” for the assessment. Because the auditing standard on going concern has been in place for decades, it is understandable that accounting and auditing standards are not totally aligned. Despite these inconsistencies, which hopefully will be resolved before the effective date, FASB has definitely stepped up to the plate and filled in the “GAAP.”