Second Quarter 2020 Amid COVID-19: Investor and Audit Committee Considerations
Going Concern: A Necessary Analysis for Investors
Continuing with our blog series, Second Quarter 2020 Amid COVID-19, Investor and Audit Committee Considerations (“Introduction,” “Cash Is Not Just King, It Is Everything”), this post covers the reality companies and their auditors face when considering the ability of a company to operate as a going concern. This post also addresses the fact that investors likely need to perform their own going concern analysis. Financial statements prepared using US GAAP and International Financial Reporting Standards (IFRS) are created based on an assumption that — very simply, not technically — the company has the ability to continue to operate as a going concern over the next 12 months.
Going Concern: The Accounting and Auditing Requirements Evolution Since the Great Recession
Subsequent to the Great Recession of 2008/2009, during which companies failed rather quickly and dramatically just having received “clean” (i.e., unqualified) opinions, audit regulators globally and in the United States took a look at the rules surrounding going concern assessments and made some amendments. In 2014, the Financial Accounting Standards Board clarified management’s responsibilities with respect to going concern assessments under US GAAP and changed the paradigm that auditors have the responsibility for going concern assessments. To date, only US auditors had defined responsibilities related to going concern. Auditors seeking to preserve the “client relationship” were shy about challenging their client’s future viability. The US audit regulator, the Public Company Accounting Oversight Board, discussed and debated this topic but only issued Staff Guidance on the topic in 2014. Internationally, the International Auditing and Assurance Standards Board, revised its guidance on going concern assessments in 2015. For IFRS, the International Accounting Standards Board dropped the suggested consideration of changes to the disclosure guidance for going concern. Further dramatic failures in 2018 of companies like Carillion — despite implementing the requirement to make a comment on going concern assessments following the financial crisis — caused the United Kingdom to further address the matter of going concern assessments and make further revisions in 2019. While changes have been made to the standards, the central concern for investors is whether these changes will result in enhanced reporting. The auditing profession remains keenly aware that stakeholders, including investors, are paying attention to their efforts and responsibilities on this issue, as a result of the pandemic.
Pandemic Necessitates Consideration of Going Concern: The Ultimate Stress Test
The COVID-19 pandemic and the dramatic contraction of demand resulting from the shutdown of the global economy — the likes of which are more rapid and substantial than the 2008/2009 financial crisis — bring the issue of not only cash and liquidity discussed in our previous blog but also the related consideration of a company’s ability to continue as a going concern to the forefront for stakeholders. A company’s cash position affects the ability of the business to continue to grow and thrive and the state of the business, our next blog, drives the ability to generate cash.
The pandemic is the ultimate stress test for a company. A company must evaluate its ability to weather the time between the onset of the pandemic and the creation of a reliable vaccine in, at best, 12–18 months. These are complicated analyses because they require an estimation of the company’s future prospects and current liquidity position against the backdrop of dramatic uncertainty. Not only are these analyses challenging, but management is also disincentivized to perform and report on them because they can become self-fulfilling prophecies.
Because of this, the topic of going concern has been a significant topic of discussion in the accounting profession over the past four months as auditors’ review — not audit — interim results. Traditionally, going concern assessments are annual endeavors at year-end, but the pandemic is requiring consideration of this issue for not only company management but for auditors during the second quarter and half-yearly reporting season. Although review reports are not issued by most auditors related to these interim reviews, most jurisdictions do require auditors to communicate with management and audit committees when they have concerns regarding a going concern in interim periods given their association with the financial information.
Regulators, such as the US Securities and Exchange Commission, the UK Financial Reporting Council, and the European Securities Market Association, have touched on this topic in recent publications. Accounting professional bodies, including the AICPA, ICAEW, ICAS, and IFAC, have recently issued commentary as have many if not all of the accounting firms (PwC, KPMG US, KPMG Canada, EY UK) in a variety of jurisdictions. As we published this blog, the Center for Audit Quality released a video on the issue of going concern, highlighting the audit profession’s attention to this issue.
This issue should be top of mind for the audit committees that oversee investor’s interests. They have an important role to play in balancing management and investor interests to ensure that the necessary work is performed and to probe the analysis to ensure that it is thorough.
Going Concern Assessments: Something Not Visible to Investors
Recent high-profile bankruptcies have highlighted the importance of going concern assessments to auditors and investors. Bloomberg’s “The Coronavirus Bankruptcies”provides an excellent infographic that uses a one-dimensional chart to highlight the multidimensional aspects of the bankruptcies, including the following: the industries affected, entity size, type of bankruptcy (i.e., reorganization or liquidation), and filing date of the bankruptcy in the United States since the onset of the pandemic in March 2020. Interestingly, less coverage is given in countries like the United Kingdom, where the Financial Times reported in “UK Insolvencies: A Sterling Job” that government actions to delay payments may have deferred such insolvencies. This same article notes a survey by the Organization for Economic Cooperation and Development that highlights actions taken in various countries to support small and midsize enterprises amid the pandemic. Concern has emerged that governments are creating zombie companies.
A recent post by Audit Analytics, “Going Concerns Related to Unknown COVID-19 Impacts,”noted 30 public company audit opinions that mention COVID-19 as a contributing factor — 14 of which issued their first going concern opinion within the past five years. Interestingly, the article highlights the various impacts that COVID-19 has or may have on the company leading to this assessment, as illustrated in the following chart:
These articles highlight the fact that the impacts of COVID-19 and the need to make going concern assessments may be more likely in front of, rather than behind, investors.
The challenge for investors is that in only a few jurisdictions (e.g., the United Kingdom being one that does require such disclosures) does the company or the auditor have an affirmative obligation to report they have performed a going concern assessment and have found no issues. In most jurisdictions, investors must presume that no mention of a going concern issue means that no problems were identified. This creates a challenge for investors. They don’t have transparency into the scenarios considered, the outcomes, or how “close a call” the decision not to report a going concern issue may have been.
Taking Analysis Back to the Basics: Investors Need to Formulate Their Own Going Concern View
Active investors must engage in fundamental analysis to make their own assessments for several reasons, including the following: (a) the potentially protracted nature of the pandemic; (b) the government support that currently exists, which may have deferred insolvencies, but, at some point, will end; and (c) the disincentives to report going concern issues. Despite having more limited information to perform such assessments, history tells us that the market generally makes such going concern assessments more effectively and timely than the company or auditor. Active investors must be alert to this possibility.
If investors have concerns regarding the company’s ability to continue as a going concern — and the investee company does not proactively and affirmatively address the issue — sophisticated investors should be asking management whether such an assessment has been performed and, if so, its results. Many investors recognize this fact, and auditors should pay attention to the information transmitted from the market on this issue.
In this second quarter, investors should, and will, care less about the precision of reported earnings per share relative to consensus estimates than they will care about the strength of the balance sheet and the basics of the business under forward-looking scenarios. The statement of cash flows and the balance sheet will be far more important than the income statement for investors evaluating companies in this and in coming quarters. Although the cash flow statement generally is not something provided at the date of the earnings release, for this quarter, it is something investors should request and closely evaluate to understand the liquidity issues highlighted in the previous blog and that are important to performing such a going concern assessment.
Investors must remember that consolidated financial statements may not be your friend this quarter. As we noted in our previous post, understanding the cash position, the location of cash, the ability of cash to move between entities, and the cash position of the parent company are not provided in consolidated financial results. Furthermore, the global nature of a business may mean that underlying subsidiary results in a particular region or business segment may be more important to consider.
In short, active investors must return to the basics of fundamental analysis in this and coming quarters. Despite being challenging amid a high degree of uncertainty, this fundamental analysis will be essential to evaluating and valuing the business and independently assessing whether the investee company is a going concern.
Image Credit: © 2020 CFA Institute