Auditor reporting and transparency about the entity’s financial condition is information critical to our turbulent economy. Amid the economic turmoil related to the coronavirus pandemic, going concern is one of the topics that auditors are most frequently asking about in their contacts with the AICPA. The information in this article does not address audits performed in accordance with PCAOB standards.
Auditors may need refreshers on what the auditing standards say about going concern and how they interact with the accounting requirements.
In FASB’s standards, management is responsible for determining whether preparing the financial statements on a going concern basis is appropriate for the entity. FASB’s standards require that management look out for a reasonable period of time, which is 12 months beyond the date when the financial statements are issued. Management needs to assess whether there is substantial doubt about the entity’s ability to continue as a going concern for that 12-month period. Management then concludes whether preparation of the financial statements as a going concern is appropriate.
I should also just quickly point out that’s the standard issued by FASB for nongovernmental entities. There are also governmental accounting standards. (specifically, for going concern, GASB Statement No. 56, Codification of Accounting and Financial Reporting Guidance Contained in the AICPA Statements on Auditing Standards.) And the reasonable period of time for this assessment by management in that case is 12 months from the financial statement date, for example, the balance sheet date.
Some special-purpose frameworks may address this evaluation of a reasonable period of time. For instance, the Financial Reporting Framework for SMEs also has the period defined as 12 months from the financial statement date, for example the balance sheet date.
For this reasonable period of time, management is required to identify whether any conditions or events are present when they’re making this evaluation that may cause significant doubt with respect to the ability to continue as a going concern. And management’s evaluation is made based on the conditions or events that are known at the time they are making that evaluation or are reasonably knowable as of that date. It essentially is, at the date of that evaluation, what do they know and then what is their conclusion around that.
I think that’s important because what that actually says is that conditions that arise or events that occur subsequent to that evaluation or subsequent to the date that the financial statements are issued, those subsequent events may result in a different outcome or a difference that does not reflect management’s evaluation. And that’s OK. Nobody can predict the future.
“Substantial doubt” from the perspective of management is defined by FASB as a “probable” threshold, which means “likely to occur.” When we get to the auditing discussion later, however, it should be noted that AU-C Section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, does not define “substantial doubt.” The auditing standards direct the auditors to consider whatever the accounting framework uses. In this case, whatever U.S. GAAP (either FASB or GASB) requires is what the auditor would use.
The auditor’s objectives
The auditor is required to consider the evaluation that has been performed by management and then to come to his or her own conclusion on whether the use of the going concern basis is appropriate for preparation of those financial statements. Another requirement is for the auditor to consider the adequacy and the appropriateness of the disclosures around the conditions and events relative to going concern. Those requirements for disclosure are essentially in the accounting framework, so they’re embedded in U.S. GAAP (either FASB or GASB).
Let’s drill down on those basic objectives and consider the steps the auditor goes through in achieving those objectives. The first one, of course, is to consider, from the auditor’s perspective, whether there are any conditions or events that cause or raise substantial doubt about the ability to continue as a going concern.
Certainly, it would be hard to deny that the pandemic and COVID-19 create events and conditions that may cause doubt about an organization’s ability to continue as a going concern. But that’s not a blanket, uniform, absolute rule in today’s environment. Depending on the sector in which the entity operates, it may or may not cause significant doubt. The example that everybody uses these days is, if your business happens to make toilet paper, the environment is probably not leading you to question your ability to continue as a going concern.
On the other hand, if you’re operating a business in the hospitality industry — restaurants, bars, airlines, cruise ships, things like that — obviously the conditions and events give rise to going concern matters.
Once the auditor establishes whether conditions and events warrant a going concern evaluation, the next step for the auditor is to ask whether management has performed the evaluation that they are required to perform under the accounting framework as described above.
If management has performed that evaluation, then the next step would be for the auditor to look at, consider, and discuss management’s evaluation with them. I think in today’s environment, certainly with today’s smaller businesses, management has their hands full with so many things, just keeping the operations going and the doors open, that they may very well have not spent a lot of time with a going concern evaluation. If management has not performed that evaluation, then the auditor is obligated to ask management to perform the evaluation required by the accounting framework.
The next step then is to consider the evaluation that management has performed. The first question of course is, do you agree as an auditor that management has identified all the appropriate conditions and events that need to be considered? Have they extended that evaluation period out to the reasonable period of time? Have they included all relevant information that’s available at that date? Remember, management’s evaluation is valid at the point at which they make that evaluation based on known information.
Management’s plans for mitigating substantial doubt
When conditions and events have been identified and management has concluded there is substantial doubt about their ability to continue as a going concern, the next step would be for the auditor to evaluate management’s plans to effectively mitigate those conditions and events to less than a probable chance of occurring.
In other words, the auditor would be asking, “Can management execute these plans, and if executed, would it mitigate substantial doubt about going concern to less than probable?”
This is a key process for auditors. Often management is going to be using cash flow forecasts in that evaluation, and that’s a significant factor in helping them determine whether their plans can alleviate substantial doubt.
When management needs to use cash flow projections to make their evaluation, then the auditor certainly has to consider those projections and evaluate the underlying data. The auditor has to make sure the underlying data used in the projections is reliable and that management has the appropriate support for the assumptions they’re using in making the projections.
The last piece of the puzzle often for management plans involves the entity’s ability to access funding from an external third party, a parent entity, an owner-manager, or some other source. That circumstance is directly addressed in GAAS (AU-C Section 570). If that’s part of management’s plans, then the auditor needs to assess whether those third parties have both the intent and the ability to provide that support if need be. And if the intent and ability are present, there is a requirement for the auditor to obtain written evidence about the intent, preferably from the third party. And if that’s all present, that may very well lead to a conclusion that the going concern has been alleviated for a reasonable period of time.
Specifically related to external funding in the current environment, we’re all very well aware of the Coronavirus Aid, Relief, and Economic Security (CARES) Act and the funding that is available through a loan program with the U.S. Small Business Administration (the SBA). It certainly appears as though most qualifying small businesses will be able to obtain a loan from the SBA to cover payroll and interest on mortgage obligations, as well as rent payments and utility payments for the covered period of that loan. And if those funds are expended as intended, the portions of the loan that are expended in accordance with the program would be forgiven.
As a result, the CARES Act is a viable source for external funding for management today as part of their plans. We certainly believe that because this program has been enacted by legislation and it’s being run by the Treasury Department involving the SBA, that the Act or the law itself is sufficient in lieu of written evidence about the intent.
Nonetheless, the CARES Act funding on its own may not be enough to alleviate substantial doubt about going concern. One aspect that the auditor would need to be thinking about, and I’m sure owner-managers and management are thinking about, is whether that funding is sufficient to get them through a full 12-month period. We need to take that consideration going forward in whether the substantial doubt related to going concern was alleviated.
Special considerations related to the COVID-19 pandemic
When management needs to do projections, auditors need to consider the reliability of the underlying data involved in those projections and the reasonableness of management assumptions. I think it’s generally well recognized that in the environment we face today with the pandemic, there is a heightened degree of uncertainty associated with trying to do projections for a 12-month period into the future.
Auditors understand that in this environment, it is inevitable that the degree of uncertainty is elevated from what it would be in other cases. Because of this, we need to look at those projections with a degree of judgment to assess whether management has done the best they can in making those projections or assessments, based on the information available to them today.
Auditors also need to ask whether management’s assumptions are reasonable. That requires a lot of judgment, but I think we have to appreciate that the robustness and the rigor of elaborate cash flow projections, for example, just may not be possible in the environment we’re in. We’re all going to have to recognize that those requirements have to be met the best they can with the information that’s available at the time the evaluation is made.
The important point then is that when a going concern evaluation involves projections and there is uncertainty involved, those types of disclosure in the financial statements that highlight the uncertainty, especially as it relates to uncertainty associated with estimates and projections, should be made in the notes to the financial statements in the risks and uncertainty area or some general footnote.
Another aspect for auditors to consider is that the conditions and events we’re facing should not be considered to be an automatic going concern report for any company. We still have to go through the process. It’s likely that we may see more going concern conclusions, but it’s not automatic. There are many, many businesses out there that have very strong financial statements, for example.
When you look at what we’re facing with the pandemic, clients with very strong balance sheets may not have significant doubt about being able to operate as a going concern for a 12-month period just based on the strength of their financials. This is not an automatic rule of thumb or conclusion to be drawn. You have to look at each circumstance individually and make that assessment. It’s possible that we may have businesses out there that can withstand this for 12 months just based on the strength of their financials.
We have received questions from members about whether it would be prudent for management to delay the issuance of its financial statements until some of this uncertainty is resolved. First of all, this would be contingent on whether management has the flexibility to delay issuance of its financial statements. Certainly, we always have to be thinking about who the users of the financial statements are and whether a delay in the issuance of the financial statements would be acceptable or would be viewed as unacceptable by users of the financial statements.
Again, you need to go back to the users of the financial statements. If the issuance of the financial statements is delayed unreasonably, that simply means the users of the financial statements will be deprived of the information they need during that extended period. That may not be in the best interests of the users, and I think that’s something management and auditors need to be taking into account.
Another aspect of this is that nobody can even come up with a consensus estimate of when this pandemic may start to look better and resolve itself, or when social distancing or travel restrictions may be relaxed. As a result, it’s a little bit of a tenuous proposition to think you’re going to wait until the uncertainty resolves itself to issue your financial statements as it may be a long time.
In the end, a client may be most interested in what the auditor’s report is going to look like. There are different types of audit reporting that can result from a going concern evaluation.
The first one is generally a rare occurrence. If, after considering the conditions and events and management’s plans, there’s a conclusion by the auditor that the substantial doubt has not been alleviated and use of the going concern basis of accounting to prepare the financial statements is not appropriate but the financial statements have been prepared on the going concern basis, then the auditor plain and simply has to issue an adverse opinion. We don’t expect that to be common at all, but that is one requirement of the standards.
In another scenario, let’s say the conditions and events did create a substantial doubt about going concern, but after considering management’s plans, including projections and availability of third-party financing or funds, we believe that significant doubt has been alleviated. If there’s adequate disclosure in the financial statements about those events and conditions and management’s plans, then the auditor could issue an unmodified report in that case, or may include an emphasis-of-matter paragraph at the auditor’s discretion.
Those disclosures are required by the accounting framework. And if substantial doubt has been alleviated by management’s plans, then management would disclose the conditions and events that gave rise to the substantial doubt as well as their plans for alleviating it, and in that case there would be no requirement to modify the standard auditor’s opinion. You could issue the unqualified opinion.
The next scenario deals with a situation where the events and conditions give rise to substantial doubt about the ability of the entity to continue as a going concern for a reasonable period of time, and then we consider management’s plans, and there’s a conclusion that the substantial doubt would not be alleviated by management’s plans.
In that case, management is required to make disclosures required by the accounting framework made by management. The auditor is required to add an emphasis-of-matter paragraph to the auditor’s report that clearly articulates the nature of substantial doubt about going concern and would direct the users of the financial statements to the appropriate disclosures in the financial statements.
Lastly, an important aspect of this is that the disclosures are required by the financial accounting framework to be made by management. Regardless of where we end up with respect to whether substantial doubt is alleviated or not, the auditor always might be in a situation of having to qualify his or her opinion if the disclosures are not appropriate in the circumstances.
A common occurrence
Although going concern is one of the top three areas we get questions about, the requirements are not actually that complex. Everybody should be familiar with them and the process involved. Certainly, as we alluded to, there are probably a handful of unique considerations that require the auditor to use professional judgment when applying the requirements of the standards.
Certainly, there may very well be an increase in the number of emphasis-of-matter paragraphs and we can expect more disclosure in the financial statements about the risks and uncertainties. But on the other hand, it’s not going to be unusual to see those. An entity’s financial statements would not look substantially different from everyone else’s financial statements if they’re done appropriately, because I think there are going to be many in that category.
For more news and reporting on the coronavirus and how CPAs can handle challenges related to the pandemic, visit the JofA’s coronavirus resources page.
— Bob Dohrer, CPA, CGMA, is the AICPA’s chief auditor. Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA’s editorial director.