Managers and Auditors Responsibilities for Evaluating Going Concern

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1 afeature rticle Managers and Auditors Responsibilities for Evaluating Going Concern Editorial Review Paul M. Clikeman Since 1981, American auditors have been required to modify the audit report if they believe there is substantial about the company s ability to continue as a going concern (American Institute of Certified Public Accountants [AICPA], 1981). During and shortly after the global financial crisis of , critics alleged that too many auditors failed to flag their clients financial vulnerabilities. Barron s columnist Jim McTague (2011) likened auditors performance during the financial crisis to watchdogs who never barked. Anne Simpson, a senior executive with the California Public Employee s During and shortly after the global financial crisis, critics complained that too many auditors failed to flag their clients financial vulnerabilities. Since then, both the Financial Accounting Standards Board (FASB) and the Auditing Standards Board (ASB) have issued new standards increasing managers and auditors responsibilities for evaluating an entity s ability to continue as a going concern. Accounting Standards Update (ASU) No defines substantial doubt, requires managers to evaluate every reporting period whether there are adverse conditions or events that raise substantial doubt about the entity s ability to continue as a going concern, and specifies information to be disclosed in the financial statements when such adverse conditions or events exist. Statement on Auditing Standards (SAS) No. 132 requires auditors to assess the appropriateness of the entity s use of the going concern basis of accounting, assess whether substantial doubt exists about the entity s ability to continue as a going concern, and evaluate whether the financial statement disclosures regarding going concern are adequate. Both standards bring American accounting and auditing practices into closer conformity with international standards. Retirement System ( CalPERS) complained in 2012, You have to be dangling off a cliff, hanging on by your fingernails before the auditor blows the whistle (Chasan, 2012). Prem Sikka (2009) identified 28 American and European financial institutions that declared bankruptcy or required government assistance within months of receiving unmodified audit reports. Sikka said auditors failure to warn investors about companies financial risks raises questions about auditor independence, the economic incentives for good audits, and the knowledge base of auditors. Published online in Wiley Online Library (wileyonlinelibrary.com). DOI /jcaf

2 108 The Journal of Corporate Accounting & Finance / January 2018 Although the financial crisis was perhaps unique in its rapidity and severity, American auditors have never had much success providing advanced warnings of their clients bankruptcies. Auditors issued clean audit reports to 42% of the 228 publicly traded companies that filed for Chapter 11 bankruptcy protection between January 1, 2001, and June 30, 2002 (Bryan-Low, 2002). That was actually an improvement over the previous five years. Auditors failed to modify the audit reports of 54% of the 673 largest corporate bankruptcies from 1996 through 2001 (Dietz, 2002). During the 20 years from 1990 through 2010, between 40% and 50% of bankrupt public companies did not receive a going-concern modified audit report prior to their collapse (Carson et al., 2013). Two factors may explain why auditors often give clean audit reports to financially distressed clients (Venuti, 2004). First, auditors are loath to anger corporate managers, who might retaliate by replacing the auditors should the firm survive. Companies who receive going-concern modified audit reports are approximately three times more likely to switch auditors than financially troubled companies who receive clean opinions (Geiger, Raghunandan, & Rama, 1998). Blay and Geiger (2013) found that auditors issue fewer goingconcern modified opinions to clients paying higher subsequent total fees than to similarly distressed clients paying lower subsequent fees. Their findings are consistent with the argument that auditors appease the clients they expect to provide higher future revenue streams. Second, auditors may fear that an audit report expressing doubt about the company s ability to continue as a going concern will become a self-fulfilling prophecy. Geiger et al. (1998) found that 19% of companies that received going-concern modified audit reports filed for bankruptcy protection within two years of receiving the opinion compared to only 6% of financially troubled companies that received clean opinions. In December 2008, at the height of the financial crisis, the Public Company Accounting Oversight Board (PCAOB) deemed it necessary to issue a Practice Alert reminding auditors of their responsibility to evaluate their clients ability to continue as a going concern (PCAOB, 2008). Since then, both the Financial Accounting Standards Board (FASB) and the Auditing Standards Board (ASB) have issued new standards increasing managers and auditors responsibilities for evaluating going concern. As of December 2017, the PCAOB was still evaluating potential revisions to AS 2415, Consideration of an Entity s Ability to Continue as a Going Concern. THE GOING-CONCERN ASSUMPTION The going-concern assumption has been an integral component of U.S. financial reporting for more than a century (Hahn, 2011). Barring strong evidence to the contrary, accountants prepare the financial statements presuming the entity will remain in operation indefinitely (AICPA, 1961). The going-concern assumption is the justification for valuing nonmonetary assets at historical cost, rather than liquidation value (Hahn, 2011). The going-concern assumption is also essential to accrual basis accounting (Storey, 1959). For example, depreciation relies on the assumption that the entity will remain in operation throughout the asset s expected useful life. Deferrals and accruals of revenues and expenses depend on the assumption that the entity will operate long enough to realize future benefits and satisfy future obligations. MANAGERS RESPONSIBILITIES In August 2014, the FASB issued Accounting Standards Update (ASU) No , Presentation of Financial Statements Going Concern (Subtopic ): Disclosure of Uncertainties about an Entity s Ability to Continue as a Going Concern (FASB, 2014). This was the first time U.S. generally accepted accounting principles (GAAP) required managers to assess explicitly whether their companies could continue as going concerns. ASU No closely follows sections 25 and 26 of International Accounting Standard (IAS) 1, Presentation of Financial Statements, which since 1997 has required companies using International Financial Reporting Standards (IFRS) to disclose material uncertainties about the entity s ability to continue as a going concern. Effective for reporting periods ending on or after December 15, 2016, American managers must evaluate during every reporting period, including interim periods, whether there are adverse conditions DOI /jcaf

3 The Journal of Corporate Accounting & Finance / January or events that raise substantial doubt about the entity s ability to continue as a going concern. Exhibit 1 lists examples of such adverse conditions and events. ASU No states that substantial doubt about the entity s ability to continue as a going concern exists when the adverse conditions and events, considered in aggregate, make it probable the entity will be unable to meet its obligations as they become due. Consistent with Topic 450, Contingencies, probable is defined as likely to occur. Defining substantial doubt is an important contribution because prior research found that auditors, judges, and financial statement users had widely varying perceptions of the meaning of substantial doubt (Ponemon & Raghunandan, 1994). If aggregate adverse conditions and events indicate substantial doubt about the entity s ability to continue as a going concern, managers should disclose the existence of these conditions and events as well as their plans to address them. Managements plans may involve the entity s assets (e.g., plans to sell underutilized assets), liabilities (e.g., plans to renegotiate existing debt Exhibit 1 Examples of Adverse Conditions and Events that May Raise Doubt About an Entity s Ability to Continue as a Going Concern Negative financial trends: Recurring operating losses Working capital deficiencies Negative cash flows from operating activities Adverse key financial ratios Other indications of possible financial difficulties: Default on loans Dividend arrearages Denial of trade credit from suppliers Restructuring of debt to avoid default Noncompliance with statutory capital requirements Need to seek new sources or methods of financing Disposal of substantial assets Internal matters: Work stoppages or other labor difficulties Dependence on a particular project Uneconomic long-term commitments Need to significantly revise operations External matters: Legal proceedings Legislation that might jeopardize operations Loss of key franchise, license, or patent Loss of principal customer or supplier Uninsured or underinsured catastrophe Source: ASU No , paragraph (FASB, 2014) DOI /jcaf

4 110 The Journal of Corporate Accounting & Finance / January 2018 or obtain new lines of credit), expenses (e.g., plans to reduce discretionary expenditures), or equity (e.g., plans to cut dividends or issue additional shares of stock). If management concludes it is probable that (a) their plans will be effectively implemented, and (b) their plans, when implemented, will mitigate the conditions or events that gave rise to substantial doubt, the following information must be disclosed in the financial statements: The principal conditions or events that raised substantial doubt about the entity s ability to continue as a going concern (before considering management s plans). Management s evaluation of the significance of those conditions or events in relation to the entity s ability to meet its obligations. Management s plans that alleviated substantial doubt about the entity s ability to continue as a going concern. If, however, the adverse conditions or events are so severe that substantial doubt remains after considering management s plans, the financial statement notes must contain an explicit statement that there is substantial doubt about the entity s ability to continue as a going concern. In addition, the company must disclose: The principal conditions or events that raise substantial doubt about the entity s ability to continue as a going concern. Management s evaluation of the significance of those conditions or events in relation to the entity s ability to meet its obligations. Management s plans to address the adverse conditions or events. The time period for which management must assess whether the entity will be able to meet its obligations as they become due is defined as one year after the date the financial statements are issued (or are available to be issued). This deviates from International Accounting Standard (IAS) 1, which specifies a period of one year from the balance sheet date. AUDITORS RESPONSIBILITIES American auditors responsibility to evaluate whether their clients can continue as going concerns dates to 1981 (AICPA, 1981). Statement on Auditing Standards (SAS) No. 34, The Auditor s Considerations When a Question Arises About an Entity s Continued Existence, required the audit report to contain a subject to qualification if the auditor, after considering management s plans, concluded that substantial doubt remained about the client s ability to continue in existence. SAS No. 59, The Auditor s Consideration of an Entity s Ability to Continue as a Going Concern, which took effect in 1989, provided more detailed guidance for how to evaluate an entity s ability to continue as a going concern (AICPA, 1988). In cases where substantial doubt existed, SAS No. 59 instructed auditors to issue an unqualified opinion with an explanatory paragraph referring readers to the entity s footnote describing its financial difficulties and management s plans. SAS No. 126 superseded SAS No. 59 in 2012, but merely redrafted SAS No. 59 s requirements as part of the ASB s Clarity Project without substantively changing the auditor s responsibilities (AICPA, 2012). SAS No. 132, The Auditor s Consideration of an Entity s Ability to Continue as a Going Concern, updates auditors responsibilities in light of the new responsibilities ASU No imposed on management (AICPA, 2017). In drafting SAS No. 132, the ASB closely followed International Standard on Auditing (ISA) 570, which the International Auditing and Assurance Standards Board (IAASB) revised in The new audit requirements apply to reporting periods ending on or after December 15, Exhibit 2 outlines the auditor s responsibilities under SAS No The new standard requires auditors to make three assessments: 1. Is it appropriate for management to use the going concern basis of accounting in preparing the financial statements? 2. Does substantial doubt exist about the entity s ability to continue as a going concern for one year from the date the financial statements are issued (or are available to be issued)? 3. Do the financial statement notes contain adequate disclosures regarding the entity s ability to continue as a going concern? The first assessment is relatively easy. The going-concern basis of accounting is appropriate for preparing financial DOI /jcaf

5 The Journal of Corporate Accounting & Finance / January Exhibit 2 Outline of SAS No. 132 (Continued) DOI /jcaf

6 112 The Journal of Corporate Accounting & Finance / January 2018 Exhibit 2 Outline of SAS No. 132 (Continued ) statements except in rare cases when liquidation is imminent (FASB, 2013). Liquidation is considered imminent when management plans to liquidate the entity or outside parties plan to force liquidation (e.g., through involuntary bankruptcy), and the probability is remote that the entity will return from liquidation. When liquidation is imminent, the entity should prepare its financial statements using the liquidation basis of accounting. The primary difference from goingconcern accounting is that the entity reports its assets at the amount of expected cash proceeds from liquidation, rather than at historical cost. The auditor s assessment of whether there is substantial doubt about the entity s ability to continue as a going concern should begin while performing the risk assessment procedures required by AU-C section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. The auditor should consider whether there are adverse conditions or events, such as those listed in Exhibit 1, that raise substantial doubt about DOI /jcaf

7 The Journal of Corporate Accounting & Finance / January the entity s ability to meet its obligations as they become due. To provide more timely warnings of financial difficulty, SAS No. 132 amends AU-C 930, Interim Financial Information. Auditors must perform inquiries and consider the adequacy of disclosures if, in the course of performing interim review procedures, they become aware of adverse conditions or events that raise substantial doubt about the entity s ability to continue as a going concern. If adverse conditions or events, considered in aggregate, raise substantial doubt about the entity s ability to continue as a going concern, the auditor should obtain from management its plans to address the entity s financial problems. After obtaining the plans, the auditor should evaluate whether it is probable (a) the plans can be implemented effectively, and (b) the plans, if implemented, will mitigate substantial doubt about the entity s ability to continue as a going concern. Exhibit 3 describes suggested audit procedures for evaluating management s plans. If management s plans include obtaining financial support from owners or third parties, the auditor should obtain sufficient appropriate audit evidence about the intent and ability of the supporting parties to provide the necessary funding. Direct confirmation provides evidence regarding a supporting party s intent. To evaluate a supporting party s ability to provide aid, the auditor should assess the party s solvency by obtaining audited financial statements or reviewing their recent bank statements. If the entity and the supporting party are in different countries, the auditor should evaluate whether trade embargos, financial transfer restrictions, or war might limit the supporting party s ability to transfer necessary funds. If the auditor concludes that management s plans alleviate substantial doubt about the entity s ability to continue as a going concern, the auditor should evaluate the adequacy of the financial statement disclosures. As discussed above, the disclosures should include the principal conditions or events that initially raised doubt about the entity s ability to continue as a going concern, management s evaluation of the significance of those conditions or events, and management s plans to mitigate the adverse conditions or events. If the disclosures are adequate, the auditor should include an emphasis-of-matter paragraph in the auditor s report (see Exhibit 4, Example 1). If the financial statements do not contain the required disclosures, the auditor should express a qualified or adverse opinion due to a departure from GAAP. In situations involving adverse conditions or events of such severity that Exhibit 3 Audit Procedures When Adverse Conditions or Events Are Identified Analyze and discuss profit and cash flow forecasts with management. Analyze the entity s latest available interim financial statements. Read loan agreements and determine whether any have been breached. Read minutes of board of director meetings for reference to financial difficulties. Inquire of the entity s legal counsel regarding the existence of litigation and claims and the reasonableness of management s evaluations of their outcome and the estimate of their financial implications. Evaluate the entity s plans to deal with unfilled customer orders. Perform audit procedures to identify subsequent events that either mitigate or exacerbate substantial doubt about the entity s ability to continue as a going concern. Confirm the existence, terms, and adequacy of borrowing facilities. Obtain and review regulatory reports. Source: SAS No. 132, paragraph A28 (AICPA, 2017) DOI /jcaf

8 114 The Journal of Corporate Accounting & Finance / January 2018 Exhibit 4 Emphasis-of-Matter Paragraphs Example 1 When management s plans alleviate the substantial doubt about the entity s ability to continue as a going concern for a reasonable period of time. As discussed in Note X to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency. Management s evaluation of the events and conditions and management s plans to mitigate these matters are also described in Note X. Our opinion is not modified with respect to this matter. Example 2 When management s plans do not alleviate the substantial doubt about the entity s ability to continue as a going concern for a reasonable period of time. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note X to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency, and has stated that substantial doubt exists about the Company s ability to continue as a going concern. Management s evaluation of the events and conditions and management s plans regarding these matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter. Source: SAS No. 132, paragraphs A55 and A52 (AICPA, 2017) management s plans do not mitigate substantial doubt about the entity s ability to continue as a going concern, the auditor should evaluate whether the financial statement disclosures are adequate. In addition to listing the principal adverse conditions or events, discussing their significance, and describing management s plans, the notes should include a statement from management indicating that there is substantial doubt about the entity s ability to continue as a going concern. If the disclosures are adequate, the auditor should include an emphasis-of-matter paragraph in the auditor s report (see Exhibit 4, Example 2). Financial statements that do not contain the required disclosures should receive a qualified or adverse opinion. SAS No. 132 requires certain communications with the client s management. While performing risk assessment procedures, the auditor should inquire whether management, while performing its own assessment, identified conditions or events that raise substantial doubt about the entity s ability to continue as a going concern. If the adverse conditions or events, considered in aggregate, create substantial doubt about the entity s ability to continue as a going concern, the auditor should request the following written representations from management: A description of management s plans to mitigate the adverse conditions or events and an assessment of the probability those plans can be implemented effectively. A statement that the notes disclose all the matters relevant to the entity s ability to continue as a going concern, including the principal conditions or events and management s plans. In addition, SAS No. 132 requires auditors to communicate with those charged with the client s governance. The auditors should communicate to the board of directors (or its audit committee) whether substantial doubt exists about the entity s ability to continue as a going concern, the auditor s consideration of management s plans, whether use of the going-concern basis of accounting is appropriate, the adequacy of the financial statement disclosures, and the implications for the auditor s report. Auditors should document their compliance with SAS No. 132 by including the following DOI /jcaf

9 The Journal of Corporate Accounting & Finance / January information in their work papers: The adverse conditions or events that led the auditor to believe there was substantial doubt about the entity s ability to continue as a going concern. The elements of management s plan that the auditor considered to be particularly significant to overcoming the adverse conditions or events. The procedures the auditor performed to evaluate the feasibility and adequacy of management s plans and the evidence obtained. The auditor s conclusion regarding whether substantial doubt about the entity s ability to continue as a going concern remains or was mitigated by management s plans. The auditor s conclusion regarding the adequacy of the financial statement disclosures. CONCLUSION The going-concern assumption is essential to accrualbasis, historical-cost accounting. But prior to ASU No , U.S. GAAP provided no guidance about management s responsibility to evaluate whether there is substantial doubt about an entity s ability to continue as a going concern or to provide related footnote disclosures. The update was intended to improve financial reporting by (a) providing a definition of substantial doubt; (b) requiring an evaluation every reporting period, including interim periods; (c) providing guidelines for evaluating whether management s plans mitigate substantial doubt; (d) requiring certain disclosures even when management s plans alleviate substantial doubt; (e) requiring an express statement and other disclosures when substantial doubt is not alleviated; and (f) extending the assessment period to one year after the date the financial statements are issued (FASB, 2014). American auditors have been criticized for decades for failing to warn investors of companies impending bankruptcies (Bryan-Low, 2002; Sternberg, 1992). Such complaints intensified during and shortly after the recent global financial crisis (Chasan, 2012; McTague, 2011; Sikka, 2009). Some auditors responded to the criticism by recommending that going-concern opinions be eliminated (Bellovary, Giacomino, & Akers, 2006; Radin & Katowitz, 2013). Advocates of repealing SAS Nos. 59 and 126 argued that (a) auditors are historians of past events, not predictors of future events; (b) readers should draw their own conclusions based on the information contained in the financial statements; and (c) auditors should not interject themselves into the decision-making process (Bellovary et al., 2006; Radin & Katowitz, 2013). Rather than repealing the auditor s responsibility for evaluating the client s ability to continue as a going concern, the Auditing Standards Board expanded the auditor s responsibility through SAS No The new standard requires auditors to assess (a) the appropriateness of the entity s use of the going concern basis of accounting, (b) whether substantial doubt exists about the entity s ability to continue as a going concern, and (c) whether the financial statement disclosures regarding going concern are adequate. Auditors must add an emphasis-of-matter paragraph to their audit report even in situations in which substantial doubt is mitigated by management s plans. By expanding both managers and auditors responsibilities for evaluating going concern, the FASB and ASB hope to provide investors and creditors with more timely warnings of when companies are likely to cease being going concerns. REFERENCES American Institute of Certified Public Accountants (AICPA). (1961). The basic postulates of accounting. Accounting Research Study (ARS) No. 1. New York, NY: Author. American Institute of Certified Public Accountants (AICPA). (1981). The auditors considerations when a question arises about an entity s continued existence. Statement on Auditing Standards (SAS) No. 34. New York, NY: Author. American Institute of Certified Public Accountants (AICPA). (1988). The auditor s consideration of an entity s ability to continue as a going concern. Statement on Auditing Standards (SAS) No. 59. New York, NY: Author. American Institute of Certified Public Accountants (AICPA). (2012). The auditor s consideration of an entity s ability to continue as a going concern. Statement on Auditing Standards (SAS) No New York, NY: Author. American Institute of Certified Public Accountants (AICPA). (2017). The auditor s consideration of an entity s ability to continue as a going concern. Statement on Auditing Standards (SAS) No New York, NY: Author. Bellovary, J., Giacomino, D., & Akers, M. (2006, January). Weighing the public interest. CPA Journal, 2006, Blay, A., & Geiger, M. (2013). Auditor fees and auditor independence: Evidence from going concern reporting decisions. Contemporary Accounting Research, 30(2), Bryan-Low, C. (2002, July 11). Auditors fail to foresee bankruptcies: In study, DOI /jcaf

10 116 The Journal of Corporate Accounting & Finance / January 2018 many companies were cleared within a year before Chapter 11 filings. Wall Street Journal, C9. Carson, E., Fargher, N., Geiger, M., Lennox, C., Raghunandan, K., & Willekens, M. (2013). Auditor reporting on going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory (Suppl.), Chasan, E. (2012, September 12). Going concern opinions on life support with investors. CFO Journal. Retrieved from going-concern-opinions-on-lifesupport-with-investors/ Dietz, D. (2002, April 26). Auditors are timid. Pittsburgh Post Gazette, C8. Financial Accounting Standards Board (FASB). (2013). Presentation of financial statements (Topic 205): Liquidation basis of accounting. Accounting Standards Update (ASU) No Norwalk, CT: Author. Financial Accounting Standards Board (FASB). (2014). Presentation of financial statements going concern (Subtopic ):Disclosure of uncertainties about an entity s ability to continue as a going concern. Accounting Standards Update (ASU) No Norwalk, CT: Author. Geiger, M., Raghunandan, K., & Rama D.V. (1998). Costs associated with going-concern modified audit opinions. Advances in Accounting, 16, Hahn, W. (2011, February). The goingconcern assumption: Its journey into GAAP. CPA Journal, 2011, McTague, J. (2011, March 19). Auditors in the doghouse. Barron s, B26. Ponemon, L., & Raghunandan, K. (1994). What is substantial doubt? Accounting Horizons, 8(2), Public Company Accounting Oversight Board (PCAOB). (2008). Audit considerations in the current economic environment. Staff Audit Practice Alert No. 3. Washington, DC: Author. Radin, A., & Katowitz, M. (2013, October). Should auditors opine on going concern? CPA Journal, 2013, 6 9. Sikka, P. (2009). Financial crisis and the silence of the auditors. Accounting, Organizations and Society, 34, Sternberg, W. (1992). Cooked books. The Atlantic, 269(1), Storey, R. (1959). Revenue realization, going concern and measurement of income. Accounting Review, 34(2), Venuti, E. K. (2004, May). The goingconcern assumption revisited: Assessing a company s future viability. CPA Journal, 2004, Paul M. Clikeman, PhD, is an associate professor of accounting at the University of Richmond, and serves on the editorial boards of Advances in Accounting Education and Issues in Accounting Education. He is the author of many professional journal articles on auditing and fraud examination. DOI /jcaf