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The worldwide COVID-19 pandemic has affected businesses of every size in every country, and the United States has been hit particularly hard. Many businesses are facing increasing doubts about their ability to continue as a going concern, and the decisions that surround that determination have an impact on both management and auditors. The authors provide an overview of FASB, PCAOB, and AICPA guidance regarding going concern issues, then discuss how these standards apply to federal programs designed to aid businesses during the pandemic, particularly those created by the CARES Act.
Currently, the United States is in the midst of the worldwide coronavirus (COVID-19) pandemic, which is stretching business and government resources alike. Representational faithfulness and transparency in financial reporting is essential to stakeholder decisions in this environment. The need for proper disclosure of financial condition is critical to the survival of the relevant financial accounting and reporting frameworks, as well as the audit profession.
The SEC recently acknowledged that in today’s business climate, historical information may be significantly less relevant than before. The SEC is urging companies to provide robust, forward-looking discussions in earnings releases and investor and analyst calls regarding their operational and financial standings, management’s COVID-19 response, and how operations and financial condition could change moving forward (Jay Clayton and William Hinman, “The Importance of Disclosure—For Investors, Markets, and Our Fight Against COVID-19,” Apr. 8, 2020, https://bit.ly/3aUL3rH). All stake-holders would benefit from an update on the current state of going concern guidance in financial reporting and auditing for large, medium, and small business entities.
This article provides an in-depth analysis of going concern responsibilities for managers and auditors of public and non-public business entities in an effort to both synthesize and clarify similarities and differences in regulatory standards. It also discusses steps that managers can take to both evaluate and alleviate uncertainties to a level where the business can continue to operate as a going concern. It concludes with pertinent information for CPAs advising or auditing small business clients during the COVID-19 pandemic.
COVID-19’s Impact on Business
That the economic fallout of the COVID-19 pandemic is disrupting business is undisputed. Companies in certain industries, such as travel and dining, are seeing drastic effects on financial results. For example, United Airlines reported in a recent Form 8-K that it expected daily revenues to be $100 million lower in March 2020 than March 2019. Similarly, the parent company of Chuck E. Cheese reported a 21.9% decline in same-stores sales in Q1 2020 versus Q1 2019, which it attributes to the closure of “on-premise dining, entertainment, and arcade rooms.” Note that January and February results, before COVID-19 caused widespread closures.
Even companies that remain operational have been affected financially by the pandemic. For example, manufacturing company Regal Beloit reports that it has drawn $255 million on its line of credit, even though it “has a strong balance sheet and does not currently intend to use the borrowed proceeds, but believes an abundance of caution regarding its cash position is prudent at this time.”
A financial accounting report, regardless of an audit, reflects the assumption that the business entity will continue as a going concern until it is liquidated. An asset liquidation generally has a negative effect on all stakeholders, including investors, creditors, accountants, managers, and the government. Financial statements, including balance sheets and income statements, do not purport to convey the market or liquidation value of an entity; however, managers and auditors must assess and disclose any uncertainties regarding the continuity of business operations on an interim and annual basis. The purpose of such disclosure, in the notes that accompany the financial statements and in the audit opinion, is to both inform and warn stakeholders of the risks surrounding the ability of the entity to meet its obligations on an ongoing basis.
Now more than ever, there is heightened scrutiny around the ability of business entities to continue as a going concern. CPAs must ensure that they are following the proper audit guidance and that they are advising clients on how to assess, evaluate, plan for, and report any substantial doubts surrounding clients’ ability to meet their obligations on an ongoing basis.
The responsibility to prepare financial statements on a going concern basis under U.S. GAAP and the International Financial Reporting Standards (IFRS) falls on management. FASB provides guidance on when and how to disclose going concern uncertainties in Accounting Standards Update (ASU) 2014-15, Presentation of Financial Statements—Going Concern: Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, codified in Accounting Standards Codification (ASC) 205-40. This covers all businesses that prepare GAAP-compliant financial reports, including those in compliance with the Private Company Council (PCC) alternative reporting framework.
Under the GAAP standard, management must assess the going concern of the business on an interim and annual basis. Managers must perform a forward-looking assessment based on relevant business conditions and events that are both known and reasonably knowable, that is, those that can be identified without an undue effort or cost on the part of management. Managers must look forward for a “reasonable period of time,” defined as 12 months from the financial statement issue date or 12 months from the date financials would have been issued for entities that are neither SEC filers nor conduit bond obligors for debt securities that are traded in a public market. For government entities and those that follow the financial reporting framework for small or medium entities (SME), the reasonable period is 12 months from the financial statement date.
Under ASC 205-40, managers must disclose an uncertainty regarding the ability of the business to continue as a going concern if “substantial doubt” exists when the conditions and events described above, considered in aggregate, indicate that it is “probable” that the entity will be unable to meet obligations as they become due. Probable is defined by FASB as “likely to occur” under FASB ASC Topic 450, “Contingencies.”
The timing of the COVID-19 pandemic, which came to the United States after the typical December 31 financial statement close, may heighten the difficulty of making substantial doubt judgments. In assessing the entity’s ability to continue as a going concern, knowledge of the potential effects of COVID-19 can be considered a subsequent event.
Although managers are not expected to predict the future, the definition of “substantial doubt” and the “probable” threshold play key roles in the assessment of the ability of the entity to meet its obligations. For example, at what point would it be likely that management has substantial doubt regarding the continuity of the business due to the COVID-19 pandemic? When the disease was first reported to exist in Wuhan, China? When it affected business operations in China? When cases started spreading globally? When it first began to negatively affect the business entity or suppliers? Or when it began substantially negatively affecting the business entity?
ASC 205-40 provides examples of conditions and events that may indicate an inability to meet obligations. These events are in line with those expressed in auditing guidance and include the following pertinent examples:
Negative financial trends, including, but not limited to, operating losses that persist over time, deficiencies in working capital, and negative cash flows from operating activities
Indications of financial difficulties, such as defaults on loans or other agreements, dividends in arrears, the denial of common trade credit from suppliers, debt restructuring in order to avoid default, a need to dispose of substantial assets, a need to seek new financing sources and methods, and noncompliance with capital requirements
Internal matters, such as work stoppages or other labor difficulties, substantial dependence on the outcome of a project, unprofitable or unviable long-term commitments, and a need to significantly revise operations
External matters, such as legal proceedings or legislation that may jeopardize the ability of the entity to operate; loss of a significant patent, license, or franchise; loss of a key customer or supplier; and an uninsured or underinsured catastrophe.
Managers must assess the above conditions and events alongside other current business factors, such as the financial condition of the entity, including available liquid funds and access to credit at the financial statement issue date; all of the entity’s obligations that are due within one year of the issue date; and the funding necessary to maintain operations given current financial conditions, all entity obligations, and other expected cash flows within one year of the issue date. If the substantial doubt threshold is met, management must next determine whether such doubt can be alleviated by management’s plans. In any case, a note disclosure must be included.
If substantial doubt is raised but is alleviated by management’s plans, the note disclosure must include the principal conditions or events leading to substantial doubt, management’s evaluation, and the plans that alleviate the substantial doubt, which should only be evaluated if they are approved prior to the financial statement issue date and if, as of that date—
it is probable that the plans will be implemented within one year, and
it is probable that once implemented, the plans will mitigate the substantial doubt surrounding the entity’s ability to continue as a going concern within one year.
If substantial doubt is raised and is not alleviated by management’s plans, the note disclosure must include the principal conditions or events leading to substantial doubt, management’s evaluation, the plans that are intended to mitigate the substantial doubt, and a statement that there is “substantial doubt about the entity’s ability to continue as a going concern,” according to ASC 205-40.
Disclosures can change as conditions and events surrounding the substantial doubt change. If the substantial doubt continues or grows in subsequent periods, subsequent disclosures should reflect that reality. If the substantial doubt is alleviated or resolved, extensive disclosures should be made in the relevant period regarding how the substantial doubt was alleviated or resolved, regardless of whether the resolution had to do with management’s plans.
PCAOB Auditor Responsibility
Issuer audits fall under PCAOB Auditing Standard (AS) 2415, Consideration of an Entity’s Ability to Continue as a Going Concern. An auditor’s initial assessment of substantial doubt regarding going concern is based on evidence the auditor has gathered through the opinion date; the auditor’s assessment is based on “relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report” (AS 2415.02).
A timing difference exists between FASB and PCAOB guidance. The PCAOB auditor evaluation period is defined as “not to exceed one year beyond the date of the financial statements being audited.” In other words, the auditor assessment period begins on the financial statement date, and not the issuance date, as in the FASB guidance. For example, if the balance sheet date is December 31 and the financials are issued on February 1, auditors must assess for no longer than one year from December 31, while managers must assess for 12 months from February 1. Managers must therefore assess for a potentially longer period than auditors. This provides for the inclusion of circumstances and events greater than one year past the balance sheet date, or the date that the financials are created. This periodic difference does not exist for government entities or SMEs, whose managers use the financial statement date rather than the issue date.