Going-Concern Warning, Even for Healthy Cos.

Companies fortunate enough to dodge the “going concern” bullet for annual reports filed this spring aren’t necessarily out of the woods, according to audit firms that remain on the lookout for indicators of distress.

Optimists have begun to point to signs that economic recovery may be creeping across the horizon. Yet even if that’s true—and it may well not be—companies with healthy operations are still at risk for financing problems that could raise doubt about the entity’s ability to remain in business, or a going concern, says Catherine Bromilow, a partner with PricewaterhouseCoopers’ corporate governance practice.

Bromilow

Tranches of corporate debt written in better times and under better terms are coming due over the next few years, she says, but constrictions on credit remain persistent. That means healthy companies could still run into trouble when current debt comes due.

And if companies are in any danger of violating debt covenants, the situation can quickly turn ugly, Bromilow adds. Debt covenants typically are tied to income from continuing operations and key balance sheet ratios. But impairment charges, or reductions in capital, can reduce income and weaken the balance sheet even for companies still generating cash.

“We want to give directors a heads-up on this,” Bromilow says. “Even if the company is continuing to generate cash and earnings, there are a few strange things we’ve been seeing in the last six months that we don’t want you to be surprised about. Don’t be surprised if you’re getting into pretty difficult conversations, even when for all intents and purposes you have a healthy company.”

Berliner

David Berliner, a partner with BDO Seidman’s consulting wing, says auditors are only required to make a going-concern determination in connection with the year-end audit. Still, auditors encourage companies to keep the conversation going year-round to minimize the chance of an unpleasant year-end surprise.

“We’re trying to work on planning techniques to try to identify issues sooner than in the past,” he says. That means companies can expect year-round questions that might indicate doubt about the ability to continue as a going concern, Berliner says.

“Don’t be surprised if you’re getting into pretty difficult conversations, even when for all intents and purposes you have a healthy company.”

—Catherine Bromilow,

Partner,

PricewaterhouseCoopers

Auditors also are taking a much deeper dive into the going-concern analysis, says Pat Ross, a partner at Southern California regional audit firm Haskell & White and the firm’s resident expert on going-concern issues. While the majority of the audit work involves verifying historical data, the going-concern analysis requires a subjective look 12 months into the future to predict if the company will have trouble remaining in business—which can involve questions and information quite different than what’s used in the rest of the annual audit.

And auditors are under more pressure than ever to get things right. Investors have asked why audit firms didn’t flag the myriad major collapses that have already occurred, and regulators have told auditors they expect to see better going-concern analyses. “If the company does go bankrupt, we’re the first ones who are going to get sued,” Ross says. “That’s always in the back of our minds. We’re double checking everything.”

That pressure is causing auditors to dig a layer deeper into documentation and management assumptions, Ross says, to assure the auditor is comfortable with the ultimate audit opinion. It also causes auditors to ask questions year-round, not just at year-end. “I encourage companies to talk to me more during the year, so they understand what my red flags are and have time to address them,” he says.

Finding the Weakest Link

Steve Kolyer, head of the U.S. structured capital markets practice at law firm Clifford Chance, says audit firms now are “much more iterative in their processes” when doing the going-concern analysis, and they’re erring on the side of caution. “Many would rather disclose the risk of going concern and be wrong, than to not do it and be wrong,” he says.

Mark Sunshine, president of First Capital, a financial-services company focused on asset-based lending, says auditors aren’t doing anything new; they’re just doing it more diligently because of circumstances. “In times of volatility, the accounting profession is supposed to look at the weakest link in a business,” he says.

Sunshine

He predicts that even if the economy starts to recover, there will be a substantial wave of going-concern opinions in the next batch of year-end reports. “There are going to be hundreds of them, thousands—and there should be, by the way,” Sunshine says. “That’s what the rules call for. It’s good disclosure.”

Auditors traditionally were under a lot of pressure from clients to allow them to skirt the going-concern determination while they worked on recovery and refinancing plans, says Steven Schertz, a partner with B2B CFO, a firm that provides CFO services to small companies. Now auditors simply cannot ignore the constrictions in credit and companies’ inability to meet debt covenants. “Banks are less willing to waive covenants that are standard,” he says.

GOING-CONCERN CONCERNS

Auditor’s Consideration of a Company’s Ability to Continue as a Going Concern:

In the current economic environment, some companies may face challenges in their ability to continue operating as a going concern. For instance, sources of liquidity may be strained because of reduced availability of lines/letters of credit from financial institutions or because of a violation of a debt covenant or other covenant. Additionally, companies may encounter limited access to the commercial paper markets, a decrease in valuation of collateral, difficulty restructuring loans, and delays in payment from customers.

The auditor has a responsibility to evaluate whether there is a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited. The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report.

The auditor’s evaluation includes considering whether the results obtained in

planning, performing, and completing the audit identify conditions and events that, when considered in the aggregate, indicate there could be a substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time. It may be necessary to obtain additional information about such conditions and events, as well as the appropriate evidential matter to support information that mitigates the auditor’s doubt. Conditions or events that, when considered in the aggregate, indicate

there could be substantial doubt about the company’s ability to continue as a going concern for a reasonable period of time include:

Negative trends—for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, adverse key financial ratios;

Other indications of possible financial difficulties—for example, default on loan or similar agreements, arrearages in dividends, denial of usual trade

credit from suppliers, restructuring of debt, noncompliance with statutory

capital requirements, need to seek new sources or methods of financing

or to dispose of substantial assets;

Internal matters—for example, work stoppages or other labor difficulties, substantial dependence on the success of a particular project,

uneconomic long-term commitments, need to significantly revise

operations;

External matters that have occurred—for example, legal proceedings,

legislation, or similar matters that might jeopardize a company’s ability to

operate; loss of a key franchise, license, or patent; loss of a principal

customer or supplier; uninsured or underinsured catastrophe such as a

drought, earthquake, or flood.

Source

Audit Considerations in the

Current Economic Environment (Dec. 5, 2008).

Given how dependent many companies are on capital granted based on standard covenants, and how routinely companies miss targets and projections because of the economic climate, companies may be required to pay “hundreds of millions” in recalled debt, Schertz says. “Given the current credit market, where is a company finding that kind of debt? There’s your going concern. What is a CPA firm supposed to do at that point?”

Kolyer concurred that banks are drawing a line on covenants. “Lenders are having their own problems on preserving their own capital,” he says. “Lenders are tightening their credit standards at the same time that borrowers need relief. That’s the anomaly.”

For companies that find themselves in the conundrum of having strong operations but weak financing, the going-concern warning may be inevitable. But it doesn’t have to become the self-fulfilling prophecy that has traditionally characterized the audit determination, experts say.

“The stigma has changed a little if you go into foreclosure now compared with five years ago,” BDO’s Berliner says. “Because so many companies are getting them, it isn’t as bad as it was in the past.”

Kolyer

The antidote to a going-concern tailspin, say Sunshine and Kolyer, is lots of disclosure. Tell the story of what’s happening to get investors comfortable with the argument that the company is viable. “If the true story is that the accounting disclosure should not really be the death knell, telling the broader context of the company’s story is a smart idea,” Kolyer says.

Clarity and accuracy will be important, Sunshine says. “The accounting profession has a nasty tendency to throw in boilerplate paragraphs, but they can disclose a lot more,” he says. “They can put in exactly why, chapter and verse, using as many words and making it as lengthy as they want.”

Of course, the turnaround has to be realistic and achievable, Ross says. “Depending on how strong and realistic it is, that’s what investors will buy into,” he explains. “You have to lay out something that’s achievable realistically.”

In the end, Sunshine says, it’s about basic business fundamentals. “The most important thing you can do is have a product or service that people want to buy at a price that allows you to make money,” he says.