Think of your business as a car. For the most part, when you stay on top of maintenance, maybe spring for something like a new water pump/ERP every so often, it’s clear sailing. Until it’s not. Because there’s no shortage of ways your car – and company – can break down on the side of the road.
But that’s what your check engine light is for, right? To give you a heads-up on potentially serious issues you should immediately address? Well, that’s precisely what a going concern assessment is for investors and, as we’re about to explain, that particular dash light wields a mighty sword.
What Is Going Concern?
The going concern principle centers around the presumption your business will continue its operations and meet its financial obligations over the next 12 months. Obviously, this assurance is important to many people and parties, so taking management’s word that everything is hunky-dory simply isn’t good enough.
That’s why companies must perform regular going concern assessments and, under some circumstances, disclose such matters in their financial statements. Once again, the financial statements function as that check engine light, providing an early warning for investors and financial statement users when potential trouble is ahead.
Interestingly, US GAAP (generally accepted accounting principles) doesn’t actually define the going concern concept. Instead, it only speaks to the presumed continuation of a company in its financial statements, except if liquidation is imminent. In which case, management would apply the liquidation basis of accounting.
Further, since US GAAP doesn’t directly address the topic, a going concern assessment doesn’t affect an entity’s financial accounting, regardless of the assessment results. Thus, a company will continue to account for its financial statements under the going concern basis of accounting unless, as you guessed, it meets the criteria for liquidation.
Going Concern: The Accounting Topic Du Jour
Nothing in our description of a going concern explains why it’s been such a hot topic recently. After all, since the FASB first introduced it in ASU 2014-15 – later codified into ASC 205 in 2017 – nothing has really changed about going concern.
The difference, of course, is the seemingly endless series of challenges companies have faced recently. Between COVID, economic turmoil, PPP loans, remote working, and everything else 2020 threw at businesses, many continue to struggle just keeping the doors open.
Therefore, the recent prevalence of going concern accounting and reporting doesn’t stem from any change to the accounting standard. Instead, it’s primarily a result of the economic environment around the coronavirus pandemic, lasting negative trends, and doubt over a company’s ability to survive.
Also, since management evaluates going concern over a look-forward period – a rolling 12 months – there’s been significantly more judgment and risk involved since 2020.
As a result, both companies and auditors have spent far more time on their assessments lately. And since the pandemic hit most industries hard, management teams and auditors across the entire spectrum of industry have been dealing with much higher levels of risk and financial ratios heading south, thus generating going concern issues well above normal levels.
When Does a Company Perform a Going Concern Assessment?
Now that we understand the going concern concept, let’s start focusing on the nuts and bolts of an assessment.
- For public companies, management must perform their going concern assessment for each annual and interim reporting period
- A private company would assess annually unless they issue interim financials, prompting assessment each annual and interim reporting period
Also, while management may use the same assessment or analysis documentation from period to period, it must continually update evaluations as the look-forward period is on a rolling 12-month basis
Evaluating for Going Concern
When it comes to performing the actual assessment, management basically follows a two-step process:
- Management determines if “substantial doubt” is raised regarding the entity’s ability to continue as a going concern. If it is not raised, the assessment stops here. However, if substantial doubt is raised, management would proceed to the next assessment step.
- Management must determine if the substantial doubt continues to exist after considering any plan to address and mitigate the doubt. Regardless whether such a plan alleviates the initial doubt, though, the guidance will require some level of disclosure in the financial statements.
Zeroing in on a plan to address and mitigate substantial doubt, management must understand the guidance sets a very high bar for what should and shouldn’t count as part of a plan. Generally speaking, the most common – and acceptable – types of plans involve:
- Disposing of or liquidating an asset or business
- Borrowing money or restructuring debt
- Reducing or delaying expenditures
- Increasing ownership equity
Specifically, for any of those items management mentions to include in the plan, it must be probable they:
- Can be effectively implemented by management, and;
- Will address the relevant conditions or events that sparked the initial substantial doubt
What Is Substantial Doubt?
Considering how many times we’ve already mentioned it, substantial doubt is obviously at the heart of a going concern evaluation. Therefore, management understanding the underlying concept is a critical component of the entire assessment process.
Substantial doubt exists when conditions or events, in the aggregate, indicate a likelihood the entity won’t meet its obligations due during the evaluation period – the 12 months following the financial statement issuance date. The evaluation period is commonly known as either the assessment period or the look-forward period.
When issuing the standard, the FASB determined the “ability to meet obligations” is the most relevant factor to consider in the assessment since this was the easiest for management to consistently interpret and apply.
To flesh out the look-forward concept a bit, let’s assume a calendar year-end company issued its 2020 financial statements on March 31, 2021. For the going concern framework, management would use March 31, 2021 as the assessment date, the date they issued the financial statements. Therefore, the 12-month look-forward period for evaluating events or conditions that may give rise to substantial doubt would extend to March 31, 2022.
That’s not to imply, however, that management is waiting until March 31 to complete the going concern assessment. In reality, they perform the assessment over time and conclude it on their assessment date.
As a best practice, management should start the process early to avoid any surprises on conclusions, especially when there’s a lot of risk and uncertainty around. This early start should include all key stakeholders – accounting, finance, legal, and anyone else involved – as well as processes to update the assessment for new information as it arises during the subsequent events period but before issuing the financial statements.
Evaluating Conditions and Events That Can Trigger Substantial Doubt
So what are the different conditions and events management should keep in mind when assessing for going concern? First and foremost, it’s important to remember that management is basing the assessment on the conditions and events relevant, known, and reasonably knowable.
As for that last term – reasonably knowable – it’s a concept the FASB added to the guidance, essentially saying management needs to make a concerted effort to identify conditions or events without undue costs or effort. That said, substantial doubt evaluation generally falls into four different categories.
1. Financial Condition
This first category comes down to a company's available access to liquidity, including lines of credit and other liquid funds like cash and cash equivalents. When gauging access to credit, it’s important management only includes credit committed to by the lender that the company can easily access.
Since liquidity needs over the next 12 months play such a pivotal role in the going concern assessment, management usually doesn’t have to proceed past this financial condition category when there’s sufficient credit to cover all liquidity needs.
Keep in mind, however, that if a company plans to obtain additional liquidity through uncommitted credit, it is not used in the evaluation of whether substantial doubt is raised, but rather when evaluating management’s plans in step two of the assessment.
2. Conditional and Unconditional Obligations Due or Coming Due
The best way for management to think about their obligations is from a contracts and commitments perspective. These could include items like:
- Financing arrangements – i.e., debt
- Lease payments
- Unconditional purchasing or funding commitments
- Pension or other retirement benefit funding obligations
Aside from those four main items, other obligations may arise that aren’t necessarily contractual, including legal proceedings and any resulting settlements. Also, when assessing for obligations, remember that it’s not exclusively focused on what’s due or even known at the assessment date.
Therefore, management must include obligations that will arise over the next 12 months that might not be reflected on the current balance sheet.
3. Funds Necessary to Maintain Operations
This third category focuses on cash flows and forecasted cash flows. Regarding forecast scenarios, be aware management typically uses more going concern assumptions and judgment during economic uncertainty. This notion is even more critical when risks on debt covenant violations in the forecasted period could trigger a violation allowing debt to be puttable by the lender.
As another best practice, management should remember that a forecast for going concern should also reconcile with forecast assumptions used in other areas of the company, including asset impairments and income taxes.
4. Other Conditions and Events
This final category is more of a catch-all than anything possibly relevant that management hasn’t already evaluated. It includes potentially adverse findings that could be relevant when management considers them in conjunction with the previous three categories. Some of the more common items we see management teams consider in this area include:
- Financial trends – recurring losses, negative cash flows, adverse key ratios
- Internal factors – changes in operations, labor disputes
- External factors – changes in laws and regulations, natural disasters, customer demand
- Other indicators of financial difficulties – the need to restructure debt to avoid loan defaults and non-compliance
Are Management’s Plans Feasible?
Returning to our previous thoughts on the feasibility of a mitigation plan, the guidance essentially ignores any unfeasible, ineffective plans addressing initial substantial doubt. That, of course, brings another question to mind – what constitutes feasibility?
Management teams often confuse intent – especially with external factors outside their control – with feasibility. Like it or not, even the best of intentions have nothing to do with the effectiveness of a mitigation plan. Instead, the guidance focuses exclusively on impact and a plan’s ability to address any substantial doubt raised.
Thus, to define and establish feasibility, management can start by looking at their past track record of implementing plans that effectively addressed factors outside their control. However, a company must also consider the counterparty and any significant changes since it last implemented such a plan since past precedent isn’t always indicative of current conditions.
This is often the case when management has a debt covenant violation and wishes to obtain a waiver. For example, if a lender provided a waiver on past covenant violations, management might expect the same for a current violation and argue they intend to receive a waiver, just as they had in the past.
Unfortunately, the guidance usually sets a high bar for overcoming substantial doubt. Therefore, most of the time, the lender must have already approved the waiver for the current violation in order for management to consider it in their plans since the approval is outside the company’s control.
In other words, what happened in the past isn’t enough to assume it will happen in the foreseeable future. Using our debt waiver example again, this dynamic is even more important during uncertain economic times or when credit markets have declined.
Otherwise, management should ask itself if any plan will have enough impact to address the liquidity concerns identified during the look-forward and in a reasonable period of time. If a company plans on divesting a portion of its business or sell other assets to cover liquidity needs, the transaction must occur in time to meet any necessary obligations coming due in the next 12 months.
Going Concern Disclosures
As we previously mentioned, without substantial doubt, there’s no impact to the company’s financial statements. Put another way, no disclosures are required. Still when there is substantial doubt, the required disclosures will depend on whether the substantial doubt raised was alleviated by management's plans or if it exists.
Under either circumstance, management is required to disclose, at a minimum:
- The principal conditions or events that triggered the initial substantial doubt
- Management’s assessment of the significance of those conditions and events
- Description of plans that alleviated – or intended to alleviate – the doubt
In addition, when management’s plans do not alleviate substantial doubt, they must explicitly disclose this fact in the financial statements by stating substantial doubt exists about the company’s ability to continue as a going concern.
An Auditor’s Consideration of a Going Concern
It’s not just management that must consistently evaluate going concern. Consideration of an entity’s ability to continue as a going concern also falls within an auditor’s jurisdiction under US GAAS (generally accepted auditing standards). Therefore, it’s important management keeps in mind that a going concern conclusion where substantial doubt exists will absolutely impact the audit report.
This will require an explanatory paragraph or emphasis of a matter paragraph in an auditor’s report. Note, however, that including these paragraphs in the audit report doesn’t change the auditor’s opinion – i.e., unqualified opinion – under the PCAOB or AICPA standards.
Also, regarding an auditor’s workflow and relative sanity, economic uncertainty goes hand-in-hand with the amount of time an auditor spends performing their own going concern procedures as well as reviewing management’s evaluation.
This is especially true when forecasting is a significant component of the conclusion. Therefore, companies should make sure they provide sufficient support and documentation to their auditors for key judgments made.
Going Concern and the Control Environment
Finally, these wouldn’t be official Embark musings unless we at least mentioned internal controls, right? As they pertain to going concern, we emphasize the fact that management still needs to consider internal controls and business processes around going concern evaluations.
This is especially important for forecasting that management uses in the assessment, where it’s critical a company designs and implements controls appropriately and uses complete and accurate data. Likewise, a company must also think about any related controls, including required review controls necessary to complete the assessment.
Ultimately, management just needs to look at going concern assessments as part of normal operations. And while no company wants to find substantial doubt lurking in the shadows, there is a silver lining to all of this – going concern assessments are the canary in the corporate coal mine, sounding the alarm when things start to go sideways and forcing management to plan for a recovery.
No matter what, just remember Embark is always here to pick up those substantial doubt reins and guide a company in the right direction.