Regulators Consider New Warning Measures for Troubled Companies

After a string of corporate failures that seemed to come out of nowhere, regulators are considering reporting mechanisms to warn investors that a company is in trouble. One central question: What should trigger such a warning?

The Financial Accounting Standards Board is reviewing accounting measures that would signal to investors that a company may have trouble paying its bills in the near future. And along the way, FASB may draw others in Washington into the dialogue, most notably the Securities and Exchange Commission and the Public Company Accounting Oversight Board. FASB still isn't sure whether it should write accounting rules requiring new disclosures—and if so, what those disclosures should be.

Auditors already are required under AU Section 341, Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, to give some thought to whether there's cause for doubt about a company's ability to continue as a going concern, says Dee Mirando-Gould, a director in the financial management practice at consulting firm MorganFranklin and a former auditor at the PCAOB. Under existing auditing standards, audit firms are expected to consider what they observe in the normal course of their audit work, and to probe deeper if they see indicators that cast doubt on a company's ability to stay in business.

After considering the circumstances and studying management's plan to deal with it, the audit firm must form an opinion about whether the company can remain in business and disclose in its audit opinion if it believes there is “substantial doubt,” Mirando-Gould says. If the company escapes the “substantial doubt” threshold established in auditing literature, “the auditor can still consider if some going-concern disclosure is warranted,” she says.

More than four years ago, FASB took up an initiative to answer investor demands for a more direct signal of trouble from management. The board believed it was management's job—not just the auditor's—to assess the ongoing viability of the business, so it proposed requiring management to tell investors when they have substantial doubt about the company's ability to continue as a going concern.

The 2008 proposal drew criticism because it digressed on a few key points from requirements in the auditing literature, such as expanding the scope of information and the time horizon that management would have to consider in making its going-concern assessment. That took FASB back to the drawing board, reconsidering whether it should instead call on management to make new disclosures about risks and uncertainties more broadly. The debate ultimately took a back seat to bigger projects at FASB meant to converge U.S. and international accounting rules.

Well, now that conversation is back on the table. The board decided, however, that it will not pursue new accounting rules meant to expose risks and uncertainties that could take a company to the brink of failure, in part because the board has separately begun developing disclosure requirements around liquidity concerns as part of its new rules on financial instruments. The board also wants to look more closely at the “substantial doubt” trigger in auditing literature to see if it can be more clearly defined for accounting purposes.

FASB has also noted that new accounting rules requiring going-concern disclosures might be redundant. FASB Chairman Leslie Seidman said during an open meeting recently that FASB staff research has turned up a host of existing SEC requirements for companies to make extensive forward-looking disclosures about their risks and uncertainties. “If management won't do it, or won't do it well, it's an enforcement issue,” she said. “I'm very concerned we are talking about adding things through this project that are already required. If there's an issue, I think it's a compliance issue.”

COMMENT LETTER SUMMARY

Below is an excerpt from FASB's initial Going Concern Comment Letter Summary providing some concerns among companies about the board's original going concern rules.

1. As of December 22, 2008, the board received comment letters from 29 respondents as summarized below.

Significant Issues

2. A large majority of the respondents generally supported the board's decision to include guidance on the going concern assessment in accounting literature. Notwithstanding the aforementioned support of the board's objective, respondents provided numerous comments on the requirements of the proposed [standard].

3. Significant issues raised by respondents addressed:

A. The type of information and the time horizon for making the going concern assessment

B. The disclosures required by the proposed [standard]

C. The definition of a going concern

D. The effective date of the final [standard]

E. Auditing literature.

Types of Information

4. AU Section 341 requires that “knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor's report” be considered when performing the going concern assessment. The proposed [standard] would require management's assessment of the going concern assumption to consider “all available information about the future.” The basis for conclusions states that “the board thinks there is no substantial difference between [the proposed wording] and the wording previously included in AU Section 341. Therefore, the board does not expect this decision to result in a change to practice.”

5. Although there was some support for the board's decision, a number of respondents disagreed with the change in wording, with at least one respondent noting that the proposed change would represent a “significant departure from … practice” (CL #21). Respondents provided various reasons as to why they think the proposed change in wording is inappropriate. Those reasons are as follows:

A. The proposed wording is too broad

B. The proposed wording raises concerns about how much time and effort should be spent in making the going concern assessment

C. The proposed wording may not be applied consistently.

Wording too Broad

6. A few respondents observed that the wording “all available information about the future” is too broad. Respondents commented that the wording could imply that management would have to consider an unlimited amount of information, regardless of its quality or relevance. The wording could also imply that management would have to consider “future conditions and events that may be distant and whose outcome may be unreliable”, rather than considering “knowledge of relevant conditions or events that exist at or have occurred.” An assessment of all available information would be “unrealistic and impracticable.” At least one respondent suggested that the board add qualifying language, such as “take into account all available information about the reasonably foreseeable future.” At least one respondent also suggested retaining the current wording of the type of information considered in the going concern assessment.

Time and Effort

7. A few respondents observed that the new wording raises questions about how much time, cost, and effort management should put forth in considering all available information about the future. Respondents asked that the board provide guidance with one suggesting that language similar to that contained in paragraph 30 of FASB [Standard] No. 157, Fair Value Measurements, be included. One respondent suggested that the costs associated with considering all available information “outweigh any benefits” to users.

Inconsistent Application

8. A few respondents observed that the new wording may lead to inconsistent application in practice. One respondent noted that the nature, volume, and type of information available vary by company.

Source: Comment Letter Summary to Initial Going Concern Proposal.

It's not immediately clear whether the SEC has focused, through its filing review process, on whether companies are adequately making such disclosures. The PCAOB is working on an update to the auditing standard to enhance the auditor's evaluation process and align the auditing standard with related accounting standards. The staff also is monitoring the discussion at FASB.

Management or Audit?

Accounting and financial reporting experts hold varying views about whether the responsibility for raising a red flag should rest on management or auditors. Mirando-Gould says she believes management should take more responsibility for warning investors about the dangers that they could go bankrupt. “There's a requirement for public companies to indicate they have the resources to continue for some number of months,” she says. “It doesn't make logical sense to me that something so important to the financial statements should not be in the accounting literature.”

Adam Brown, a partner at BDO USA, says there may indeed be more of a practice issue to explore than a hole in the standards to plug. “There's a potential conflict for management,” he says. “They're running a business they believe in, so it could be difficult for them to say ‘we're not going to get there.'”

Brown says that's been the logic in the past for relying on auditors to give the signal. “Auditors are supposed to be skeptical and test management's assertions,” he says. “That's been the justification. Auditors are supposed to be the independent check.”

Michael Scanlon, a partner with law firm Gibson Dunn & Crutcher, says management should make the assessment because it has first-hand information on the entity's financial position. “But I can also see the flaw that management's view is going to be imbued with some level of bias,” he says.

If FASB plans to press forward with an accounting requirement, the board needs to refine the issues raised in earlier proposals, especially on the time horizon, he says. While auditing literature confines the future time horizon that must be taken into account to one year, FASB wanted its rule to look further into the future.

FASB also needs to take a crack at defining “substantial doubt,” says Chuck Evans, a partner with audit firm Grant Thornton. “In practice, we think we know what it means,” he says, “but it has to be coordinated with the accounting literature so we don't use a different meaning.” Evans believes there's benefit to having a requirement for both management and the auditor to consider the going-concern question. “Management ought to be involved in that decision,” he says. “They are management's disclosures, not the auditor's disclosures.”