There is little question that, in the wake of the credit crisis (think Lehman Brothers and the AIG bailout) and the MF Global debacle, advance warnings about a company’s failing financial health would be welcomed by investors. One such warning comes through the disclosure of “going concern.”
A basic tenet of financial reporting for any business entity, whether public or private, is that its financial statements are prepared based on the assumption that the entity will continue to operate as a “going concern.” That is, the entity will be able to meet its financial obligations as they come due and possesses sufficient liquidity and capital resources to continue to operate for at least the next 12 months or so. When these conditions are not met, users of the financial reports, including investors, should be made aware of the facts and circumstances surrounding the entity’s ability to continue as a viable operation.
From severe liquidity and capital resource constraints that would interfere with the ability to make good on a major debt repayment to changes in a major customer or vendor supply agreement, investors should know about it. The sooner, the better.
In a March survey of CFA Institute members on going concern, 81 percent of respondents indicated that the accounting concept is important to the analysis of a company. Further, 61 percent of respondents said that the global financial crisis has highlighted problems with going concern reporting.
Who Should Report “Going Concern” Matters?
The Financial Accounting Standards Board (FASB) and the Public Company Accounting Oversight Board (PCAOB) are looking at going concern reporting. Right now, the independent auditor is required (under auditing, not accounting standards) to disclose in its standard auditor’s report if there is substantial doubt about a company’s ability to continue as a going concern. It is the responsibility of the auditor, not management, to conduct the going concern assessment.
However, the FASB recently has considered making the going concern assessment part of the accounting standards and, hence, the responsibility of management along with that of the independent auditor. The U.S. Securities and Exchange Commission (SEC) also has an interest in these disclosures as part of its reporting requirements on liquidity disclosures and the company’s business prospects in Management’s Discussion and Analysis (MD&A).
For its part, CFA Institute believes that the primary responsibility for reporting going concern matters rests with the company’s management. That’s because management is best positioned to make an early assessment of the financial health of a company by reporting this in the company’s financial statements and in the MD&A. The independent auditor then comes in after the fact to assess the company’s ability to continue as a going concern.
The aforementioned CFA Institute survey found that 81 percent of survey respondents believe it’s the responsibility of management to report to investors when a question arises as to whether a company will continue as a going concern, followed by the independent auditor (74 percent) and the entity’s audit committee (58 percent). These survey results support that the responsibility for reporting going concern rests with multiple parties.
What Should Be Disclosed in “Going Concern” Reporting?
If the independent auditor and/or management conclude that an entity may not continue as a going concern, the majority of the respondents to the survey said the following disclosures should be provided to investors:
- Risks that directly or indirectly affect the determination that there is a question as to whether the entity is a going concern.
- Expected courses of action that bear on the financial flexibility of the entity as well as a reasonably detailed discussion of the entity’s ability to generate sufficient cash to support its operations during at least the 12 months from the date of the financial statements.
The PCAOB is undertaking going concern assessments and reporting requirements through its standard setting project on revising the standard auditor’s report. Through the objectives below in its project on Disclosures about Liquidity Risk and Interest Rate Risk, the FASB is also addressing the issue as it relates to disclosure in financial statements:
- Provide information about the risk that an entity will encounter difficulty in meeting its financial obligations.
- Provide information that expresses an entity’s exposure to fluctuations in market interest rates.
FASB Defers Decision on “Going Concern” Disclosures
However, in mid-April the FASB decided not to require additional qualitative disclosures related to a company’s ability to remain a going concern. The principal reason behind its 5-2 decision was that the Board did not want to act in isolation, maintaining that disclosure of going concern issues was better handled through a collaborative effort with the SEC and the PCAOB.
Although we understand the importance of working in a collaborative manner, we support the minority in the decision who felt that the added qualitative disclosures are in the best interest of investors. The FASB missed an opportunity to further enhance the financial statements with important disclosures which would alert investors to potential going concern matters. Given the typically slow pace at which financial reporting changes develop for just one standard setter — not to mention two other regulatory bodies — this decision seems to indicate that investors will likely continue to be disadvantaged.