Back to the Drawing Board for FASB on Going-Concern Warning

It may be management's job to explain a company's financial position to investors, but there's little faith in executives' ability to be frank when the company is in danger of going under.

That reality has sent accounting and reporting standard setters on a five-year odyssey in search of the best way to give investors fair warning—and after several fits and starts, they're no closer to a solution than when they took up the issue five years ago.

The Financial Accounting Standards Board decided recently it will revisit the question of whether it can craft a disclosure requirement that will compel management to tell investors when they think the company is in danger of collapse. Earlier this month, the board said it will first develop guidance about how and when a company should apply the liquidation basis of accounting, meaning management is focused more on liquidating the business than operating it. Then, the board will look at how to provide guidance on whether and how a company should assess its ability to stay in business as a going concern and, if not, what kind of disclosures that should entail.

It's something of a fresh start, says Bruce Pounder, director of professional programs for accounting training firm Loscalzo Associates. The project first began in the spring of 2007 to consider how to include a requirement in U.S. Generally Accepted Accounting Standards for management to give investors an early warning on going-concern issues rather than leaving the job solely to auditors, he says. Auditors are required under standards of their own to consider whether a company is in jeopardy and to provide notice in their audit report if they conclude that it is. Investors appealed to FASB to make it a management requirement for two primary reasons: management is in the better position to know, and they're already required to do so under International Financial Reporting Standards.

It's been a long haul with twists and turns along the way—most recently with FASB going back to the drawing board—because there is tension between two core ideas, Pounder says. “The first idea is that management should be responsible for communicating the financial position and financial performance of an entity,” he says. “The other idea is that management can't be trusted to disclose something as important as whether an entity will or won't be able to continue as a going concern. There needs to be independent verification that management is telling the truth and the whole truth in a timely way. That's the reason we have external auditors in the first place.”

After FASB opened the project in 2007, it developed a proposed accounting standard and issued it for public comment in what was expected to be a fairly straightforward process. The feedback from commenters, however, got the board thinking harder about the challenges, says Pounder. In auditing standards, auditors are required to look a year into the future to consider whether they think a company is in danger of folding. FASB extended the time horizon beyond a year with vague language that concerned preparers and auditors about how long the time horizon should be and how to apply it in practice.

Dennis Beresford, a former FASB chairman and current audit committee chairman at Legg Mason and Fannie Mae, says the board never managed to resolve the concerns. “Corporations were saying we're going to get into a lot of arguments with the auditors about what exactly this means,” he says.

“There needs to be independent verification that management is telling the truth and the whole truth in a timely way. That's the reason we have external auditors in the first place.”

—Bruce Pounder,

Director of Professional Programs for Training,

Loscalos Associates

Ernie Baugh, national director of professional standards for audit firm Mayer Hoffman McCann, says the vague timeline flawed the original plan. “You had to look at everything that could possibly happen with no term limit on it,” he says. “That would be very hard to do.”

The financial crisis in 2008 and 2009 brought new pressure on the question of why companies like Lehman Brothers could collapse with no warning. The Public Company Accounting Oversight Board fielded questions from angry investors about why auditors didn't issue going-concern opinions, even as the board has said its inspections did not reveal significant problems with auditors applying existing standards.

Self-Fulfilling False Positives

Beresford attributes the unforeseen collapse of companies like Lehman Brothers to the rapid changes in market conditions that are nearly impossible to predict. He worries standard setting—for accounting or auditing—that would try to elicit more going-concern warnings could do more harm than good. “I question whether we really want to have more false positives,” he says, or more going-concern disclosures where companies may be more stable than the disclosure would suggest.  

CAN IT CONTINUE?

Below are PCAOB suggestions on how to identify conditions and events that indicate a company is unable to continue as a going concern:

Pursuant to PCAOB standards, the auditor's going-concern evaluation is based on the auditor's knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor's report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve other audit objectives. AU sec. 341 indicates that it is not necessary to design audit procedures solely to identify such conditions and events as the results of auditing procedures designed and performed to achieve other audit objectives should be sufficient for that purpose.

The staff is considering whether to add requirements for the auditor to perform procedures in all audits for the purpose of identifying conditions and events that, individually or in the aggregate, could indicate that there is substantial doubt about the company's ability to continue as a going concern. Examples of specific procedures that might be required include:

A. Reading management's going-concern assessment or equivalent information regarding management's expectations about future performance and liquidity, such as company forecasts;

B. Inquiring of certain management personnel regarding their knowledge of matters that could affect the company's ability to continue as a going concern;

C. Reading relevant company filings with the SEC that might identify matters that could affect the company's ability to continue as a going concern (e.g., disclosures in Form 8-K regarding disposition of assets, triggering events that accelerate or increase a direct financial obligation or an obligation under an off-balance sheet arrangement, and material impairments);

D. Assessing the company's liquidity and capital resources and expected future cash flows for the period covered by the going-concern evaluation; and

E. Evaluating whether there are conditions and events that raise doubt about the company's ability to continue as a going concern based on the preceding procedures, relevant information from the risk assessment procedures, and other audit procedures performed by the auditor.

A proposed standard also could require additional procedures to be performed once the auditor identifies such conditions or events, including procedures to evaluate management's plans for mitigating the adverse effects of those conditions and events.

Source: PCAOB.

It raises concern over the “self-fulfilling prophesy,” he says. Companies have long argued that the going-concern disclosure itself is a death knell because it compels investors to withdraw support that virtually assures a company's collapse. “It is very concerning to corporations to be stigmatized with a going-concern qualification if they don't feel it's deserved,” he says.

As FASB begins its deliberations again on whether and how to require a going-concern disclosure, the Public Company Accounting Oversight Board also is looking at whether to update auditing standards on the topic. Both boards are discussing whether to more clearly define key terms that would create a threshold for the disclosure, such as “going concern” and “substantial doubt,” and what time horizon to require management or auditors to consider. Recent discussion at a PCAOB meeting with its Standing Advisory Group suggests the board would prefer to see what FASB develops to assure its own rules would not conflict with GAAP or set different standards.

Neri Bukspan, executive managing director at Standard & Poor's, says users of financial statements would be best served by a discussion of how to assure financial statements adequately convey the risks of investment so readers can see for themselves whether the company may be in trouble. “The ideal solution would be that financial statements provide investors with information about the financial health of the company—the favorable and unfavorable elements,” he says.

It's not as critical that FASB establish a principle or a bright line that defines when management must make a particular disclosure, he says. Financial statements already contain too much boilerplate language, and he fears a going-concern disclosure requirement would become boilerplate as well. Instead, “the story is broader—whether investors get the right information that will allow them to understand the risks and rewards and the trends even before a company has been identified as a near imminent failure,” he says.