Auditors to Maintain Pressure on Going-Concerns

Perhaps the economy has indeed begun to revive, but auditors’ questions about going concerns aren’t going away any time soon.

In fact, some auditors expect the question of whether a company can continue as a going concern to be as big or bigger at the end of this year than the year before.

Dohrer

“While there is a lot of noise coming from higher levels of the U.S. economy about the abating recession, we are not seeing that necessarily in our client base,” said Bob Dohrer, an audit partner with McGladrey & Pullen. “I think the going-concern consideration will be elevated this year because of poor financial results. The companies we deal with in the markets have not seen the turnaround yet. I don’t think it’s a real rosy picture.”

Management and auditors alike are paying much closer attention to the leading indicators of financial trouble that could raise a red flag, said Janice DiPietro, managing partner for consulting firm Tatum. “The audit firms for our clients are having the dialogue around going concerns even around acceptance of a new client,” she said. “The conversations are happening early and often.”

Under current accounting and auditing rules, it’s the auditor’s job to reach a conclusion about whether there’s reason to doubt that a company will be in business a year later, although management has some responsibility to disclose circumstances that might play into such a determination. The Financial Accounting Standards Board is working on a new rule that would require management to reach its own determination, but it hasn’t been finalized yet so likely will not be effective for 2009 year-end financial reporting.

That means it’s still the auditor’s ultimate responsibility to say whether there’s cause for concern. And according to a recent analysis by financial advisory firm Duff & Phelps, a substantial number of public company bankruptcies are not foretold by auditors in the form of a going-concern opinion.

Duff & Phelps studied bankruptcy filings and going-concern opinions to look for some common threads that might make business failures easier to predict and head off. It found that half of medium to large public companies that received a going concern opinion in 2007 were in fact still in business 18 months later. On the flip side, 63 percent of companies that filed for bankruptcy in 2008 did not receive a going-concern opinion from their auditors.

To some extent, said Mike Kelly, managing director for Duff & Phelps, it’s reflective of the times. “It’s increasingly difficult in this economic environment to predict a going-concern risk,” he said. Companies enjoyed relatively easy credit and light debt covenants when the market suddenly turned, he said. Now recovery seems near or at hand, but it’s not a given. “All of those combined make it very difficult for both the management team as well as the auditors to evaluate the going-concern risk.”

DiPietro

DiPietro says the difficulty in foreseeing a going-concern question is uncertainty over external forces. Companies may do a great job of managing circumstances that are under their control, but they get blindsided by customer or supplier problems, for example, that can’t easily be predicted. “That’s what has really heightened in the past year,” she said.

As part of its research, Duff & Phelps wanted to identify the risks or financial metrics most associated with an eventual bankruptcy, so it studied every public company with revenue of $25 million or greater that has received a going-concern opinion in the past six years, said Kelly. The firm found more than 200 metrics that could indicate a going-concern risk, but it found six indicators that are clear leaders, he said.

Using that data, the firm developed a proprietary tool it now uses with clients to help them see around the corners. Kelly wouldn’t identify the six factors specifically, but he said they relate to profitability, financial returns, leverage, liquidity, market values, and net worth. “The factors themselves are fairly intuitive,” he said. “I don’t think the factors themselves would surprise anyone.”

The real value to the research, said Kelly, is it helped show how the factors combine to create a going-concern risk, as well as the tipping points for each of those factors that seems to push a company beyond saving. The tool helps the firm work with companies to identify greatest risks and develop plans to mitigate them, Kelly said.

GOING CONCERN UNCERTAINTY

Audit Analytics on the number of audit opinions uncertain of their going-concern assumption (Year 2008 Estimated):

Year

Number

2000

2,805

2001

3,065

2002

2,901

2003

2,617

2004

2,600

2005

2,747

2006

2,924

2007

3,293

*2008

3,589

*Year end 2007 experienced the highest number of going

concerns so far this decade, but it is estimated to be

surpassed by 2008.

Source

Audit Analytics Data on Going Concerns (2009).

Chris Wright, managing director at consulting firm Protiviti, said the going-concern finding ultimately is a judgment call, but one rooted in statistical analysis. The cash flow projection is key, he said, but borrowing capacity also is crucial.

The big challenge with the going-concern finding, said Wright, is it relies on historical data and projections, neither of which can perfectly predict the future. “You’re managing a lot of variables,” he said. “It becomes a complex calculation, then a judgment call. … With a lot of variables in a dislocated market, it’s very difficult to pin down.”

Dohrer said financial ratios often play a big part in the going-concern analysis—things like debt-to-equity ratios and how quickly inventory is turning. Beyond the obvious cash flow concern, “if a company was able to obtain financing through equity transactions or private placements, how quickly after the fundraising event is the company burning through that cash?” he asked.

DiPietro said she wouldn’t expect to see every going-concern opinion to be followed by a bankruptcy, but she would expect to see the majority of bankruptcies foretold by a going-concern opinion. “Unless there’s been a very rapid change in market conditions or financing, you would expect that a high percentage of organizations that file for bankruptcy did in fact have a going-concern opinion,” she said.

Wright

Wright and Dohrer saw things differently, however. “I wouldn’t cast judgment on the auditors or the registrant community” if a bankruptcy is not preceded by a going-concern opinion, said Wright. “There are so many events that can happen in the middle of the year, after the issuance of financials, that cannot be foreseen. I don’t know that anyone in March of last year would have predicted the financial crisis we saw in September.”

Dohrer said it’s a “worst case scenario” for auditors, but it can happen. Auditors may consider a going-concern risk but become comfortable with management’s plan for a turnaround. “At the end of the day, it’s an opinion with judgments involved,” he said. “This year particularly, we will be focused on taking a second look at the opinions that are being issued and making sure that good judgment has been applied.”