Recent events, such as the fiscal crisis of 2007–2008 and the economic recession that followed, have prompted concerns about whether investors have received sufficient notice of impending corporate bankruptcy. According to data available from New Generation Research, from 2009 to 2013, 561 public companies filed for bankruptcy, and investors had little, if any, warning in some cases (see http://www.bankruptcyrates.com). As a result, the auditing profession has been called out by some for failing to warn financial statement users of the potential for bankruptcy. Anne Simpson, senior portfolio manager and investment director, global governance at the California Public Employees’ Retirement System (CalPERS), called out the failures of the current system at a roundtable meeting of the IASB. She stated, “A going concern warning from an auditor is rarer than a hen’s teeth. You have to be dangling off a cliff, hanging on by your fingernails before the auditor blows the whistle.” Simpson added that “what should be an extremely useful form of audit communication to capital providers, it seems to us is not being used (Emily Chasan, “Going Concern Opinions on Life Support with Investors,” CFO Journal, Sept. 12, 2012).
Academic research suggests that 40% of public company bankruptcies are not preceded by audit reports modified for going concern uncertainties. In addition, research indicates that auditors have increased the frequency of issuing going concern reports in the last decade (E. Carson, N. L. Fargher, M. A. Geiger, C. S. Lennox, K. Raghunandan, and M. Willekens, “Audit Reporting for Going-Concern Uncertainty: A Research Synthesis,” Auditing: A Journal of Practice & Theory, vol. 32, supp. 1, 2013, pp. 353–384). However, shareholders in favor of early warnings demand more than the auditor’s report. Given that management is most familiar with the entity’s condition, many have called for management to assess the entity’s future viability.
The idea of shifting responsibility to management had been considered by FASB for many years and was recently finalized in Accounting Standards Update (ASU) 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40). The new standard requires management to assess and provide related disclosures about an entity’s ability to continue as a going concern. It is effective for financial statements ending after December 15, 2016, with early application permitted, and it is applicable to all companies and not-for-profit entities.
While the update brings to fruition a concept that FASB has been working on since it was added to the agenda in 2007, discussions regarding management’s role have been fraught with controversy. In fact, FASB originally voted on whether to require management to assess going concern in January 2012, which culminated in a 4–3 vote against expanding management’s responsibilities. The dissenters cited concerns such as management not being able to provide an objective assessment and an assessment becoming a self-fulfilling prophecy. After reconsidering the requirement, FASB issued a revised exposure draft in June 2013 for comment. Although most comment letters were in favor of requiring management’s assessment, opinions differed regarding the time frame and threshold, resulting in further revisions. In August 2014, FASB ultimately issued the final version of the ASU in a 5–2 vote. FASB’s intent was to improve the timeliness and quality of disclosures about going concern uncertainties and provide a gauge against which the adequacy of such disclosures could be assessed.
A Reporting Gap
ASU 2014-15 resolves a gap in the financial reporting framework. Financial reports rest on the assumption that the entity will persist into the foreseeable future. This concept has long been understood by accounting professionals as the going concern assumption—dating back to 1953, when it was formally incorporated into the U.S. accounting literature as Accounting Research Bulletin (ARB) 43, Restatement and Revision of Accounting Research Bulletins. Despite the concept’s long tenure in authoritative literature, U.S. GAAP has contained a gap in guidance related to the going concern assumption for many years. While U.S. GAAP directs management to prepare financial reports under the going concern assumption unless liquidation is imminent, official guidance regarding management’s responsibility for assessing the entity’s ability to continue as a going concern has been lacking [FASB Accounting Standards Codification (ASC) 205-30]. Furthermore, no guidance existed to clarify the nature and extent of related going concern disclosures or to dictate the appropriate circumstances for disclosing going concern issues.
The SEC addressed the going concern assumption by requiring independent auditors of issuing entities to evaluate going concern. [See section 10A(a)(3) of the Securities Exchange Act of 1934.] In addition, the ASB and the PCAOB require auditors to evaluate going concern for a reasonable period of time. Accordingly, until this year, independent auditors were entrusted with the sole responsibility for evaluating going concern. Under the auditing standards, if substantial doubt exists, auditors must evaluate management’s plans to alleviate it. If the auditor continues to believe that there is substantial doubt, in spite of management’s plans, the auditor must assess the adequacy of disclosure and add an explanatory paragraph.
ASU 2014-15 resolves a gap in the financial reporting framework.
Even though auditors have been required by the operative standard to assess the adequacy of note disclosures regarding going concern uncertainties, the lack of an explicit financial reporting standard led to variations in the timing, nature, and extent of disclosures in practice. This gap in U.S. GAAP needed to be filled to enhance the comparability of financial statements.
Provisions and Implementation
By extending responsibility to management and providing disclosure guidance, FASB aims to improve the reporting of going concern uncertainties. ASU 2014-15 requires management to make interim and annual assessments of going concern and provide related footnote disclosures. Specifically, management must assess known or reasonably knowable conditions that raise substantial doubt about the entity’s ability to continue as a going concern. Substantial doubt exists if it is probable that the entity will not be able to meet its obligations as they become due, with the term “probable” referring to an event or events that are likely to occur. (See ASC 450-20-55-2.) Lastly, the time period for consideration is one year from the issuance of financial statements for public companies and one year from when the financial statements are available to be issued for nonpublic companies.
When substantial doubt exists about an entity’s ability to continue as a going concern, management must consider its plans to alleviate the concern. Note disclosures should include the principal conditions or events that raise substantial doubt, management’s evaluation of the significance of the conditions, and management’s plans to alleviate the substantial doubt. If substantial doubt continues to exist despite management’s plans, the disclosures must also include an explicit statement that there is “substantial doubt about the entity’s ability to continue as a going concern.”
THE ASB INTERPRETATIONS
By Howard Levy
The ASB interpretations issued in January 2015 (AU-C section 9570) carry no effective date and, therefore, may be applied now. They guide auditors as to the use of terms in the applicable reporting framework, particularly the definitions of “reasonable period of time” and “substantial doubt.”
Because the new FASB going concern standard (ASU 2014-15, ASC 205-40) is not effective until annual and interim periods ending after December 15, 2016, its definitions of these critical terms and the ASB interpretations thereof do not yet need to be used by auditors when reporting on financial statements prepared in accordance with U.S. GAAP, unless the reporting entity has elected early adoption of the provisions of ASC 205-40. Nevertheless, because there are no predecessor definitions of these terms in U.S. GAAP, and because the current definition of “reasonable period of time” in AU-C section 570 can be viewed only as a minimum, FASB’s definitions can serve temporarily as nonauthoritative guidance for the exercise of auditor judgment. Nothing precludes an auditor from reporting on U.S. GAAP financial statements as guided by these definitions prior to the adoption of ASC 205-40.
In addition to the financial reporting disclosures, the management of public companies must document and implement internal controls around the going concern assessment, among others. The internal controls should cover all portions of the decision-making framework. Management must determine appropriate financial and nonfinancial indicators for when additional testing and documentation would need to be completed. For entities that are fiscally sound, the documentation and controls would be less complex, and no additional disclosures would be necessary. For public entities that did not meet those indicators, management must document, evaluate, and test the effectiveness of the internal controls around the plans to effectively mitigate the substantial doubt. A decision flowchart in ASU 2014-15 provides a useful example of the decision process an entity may use when applying the standard.
Implementation of ASU 2014-15 will provide benefits to the users of financial statements through a reduction in the variety of information presented. First, the standard will be required for all private, public, and not-for-profit entities and will reduce the diversity seen in going concern disclosures across these groups. Second, the standard will enhance the consistency of the disclosures within the footnotes and give auditors a benchmark for evaluating their adequacy. All companies will be required to disclose any substantial doubts about their ability to continue as going concerns and what is being done to alleviate them. In addition, management will assess the plans to alleviate doubt and the steps to be taken. The increased and consistent disclosure from management will allow financial statement users to evaluate the information presented and make their own decisions.
As noted previously, FASB also revised the timeline for considering going concern uncertainties. More importantly, the one-year forward-looking period benefits users by starting one year from the financial statement issuance date, as opposed to the previous standard of one year from the balance sheet date. By requiring the timeline to start from the financial statement issuance date, FASB is preventing the practice of auditors delaying the issuance of financial reports beyond the usual time frame in order to reduce the amount of time covered. Pushing back the assessment timeline provides users with more current and relevant information. Research indicates that 98.3% of bankrupt firms survive for at least one year from the issuance of a going concern audit report (Carson et al. 2013). This is consistent with concerns that a shorter window for management’s assessment might not capture companies that file for bankruptcy within a slightly longer time horizon.
While the guidance applies to both public and nonpublic entities, opponents argued that public entities were already disclosing going concern issues in the MD&A (management discussion and analysis) section of Form 10-K. FASB considered such redundancies for SEC registrants but concluded that the update represented an overall improvement.
The new standard aligns U.S. GAAP with IFRS by extending responsibility to management to assess the reporting entity’s ability to continue operations as a going concern. However, IFRS [in International Accounting Standards (IAS) 1, Presentation of Financial Statements] differs from U.S. GAAP by requiring management to consider a time period of at least one year, whereas U.S. GAAP sets an upper limit at one year. Although the IASB considered amending the disclosure requirements about going concern, the board recently voted to remove the issue from the agenda.
In September 2014, the PCAOB issued Staff Audit Practice Alert 13, Matters Related to the Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern, to remind auditors of the existing requirements. The update specified that auditors are expected to apply AU section 341 when evaluating whether audit reports should be modified to include a going concern paragraph. In January 2015, the AICPA’s Auditing Standards Board (ASB) issued an interpretation of existing going concern guidance (AU-C section 9570, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern”). The interpretation clarifies four topics: substantial doubt, reasonable period of time, interim financial information, and consideration of financial statement effects. The ASB’s guidance should be used by auditors when planning and performing an audit of non-SEC issuers.
Filling the Gap
The authors believe that a significant gap in U.S. GAAP has been filled with FASB’s issuance of ASU 2014-15. The standard will require some significant changes in control policies and procedures for management, including formal documentation thereof. For auditors, this update will provide guidance for what management needs to evaluate in regard to the going concern assumption. Users of financial statements will likely see even fewer going concern modifications in audit reports, but they will have more consistent data upon which to base their decisions. Academic researchers will be able to examine whether the improved consistency of disclosures and the actions to be taken by management to alleviate substantial doubt about going concern will outweigh the likely decrease in companies filing financial reports with a going concern uncertainty disclosure. Although it will be some time before companies are required to implement the new standard, there will likely be pressure for early adoption when applicable.