Will FASB's Going Concern Warning Rule Work in the Real World?

After years of batting around ideas for an early warning to investors that a company is in trouble, consensus is growing that management should be responsible for raising a red flag. That consensus crumbles, however, when the conversation turns to exactly how to produce a rule that can work in practice.

The Financial Accounting Standards Board will wrestle with those issues in the coming months as it sifts through feedback to its proposal to require companies to issue new disclosures about whether there's a risk that a company will not be able to continue operating as a going concern. FASB published its proposal in June and accepted written comments through late September. The majority of those who submitted comments agree that, in theory, if someone is going to be in charge of warning investors that the company is in trouble, it should be management.

“We are past the point of management resisting the duty to report,” says Dee Mirando-Gould, senior technical director at consulting firm MorganFranklin. “Is there going to be management resistance? Yes. But beyond that, there's a lot of support for having something in the accounting literature to say this is your responsibility.”

Auditing rules have long required auditors to assess whether a company is at risk of failing. Even before the financial crisis, though, FASB began to look at how to give management the primary duty for assessing the going concern question under U.S. Generally Accepted Accounting Principles. Its first proposal on the topic, issued in 2008, met heavy resistance. After considering several alternatives, FASB decided to try again. Dan Noll, a director at the American Institute of Certified Public Accountants, is pleased FASB persisted. “It's been the auditor who has to drop the hammer and get certain things done,” he says. “Now management has to take certain steps. This says management really does have to go first.”

The proposal currently on the table says companies should evaluate going concern uncertainties every reporting period and consider whether there are risks looking out as far as 24 months. If the company determines within the first 12 months, it's more likely than not that it will have trouble meeting its routine obligations without extraordinary measures, then it must say so in footnote disclosures. If it's known or probable that the bills won't get paid looking out 24 months, even with heroic measures, it must say that too. The standard provides detailed guidance around the timing, nature, and extent of those disclosures.

A handful of the issuer companies that sent comment letters—as opposed to accounting organizations or other service providers with an interest in financial statements—haven't yet swallowed the notion that management should be required to make such disclosures at all. Goodyear, for example, says existing requirements under auditing standards and in management discussion and analysis give investors all the notice they need.

A Litigation Magnet?

Goodyear and Pfizer both point out that the footnote disclosures FASB is suggesting would involve forward-looking information that is not protected under existing safe harbor rules. “We are concerned that public issuers would become subject to private securities claims as a result of these disclosure requirements,” writes Richard Noechel, vice president and controller at Goodyear.

“Is there going to be management resistance? Yes. But beyond that, there's a lot of support for having something in the accounting literature to say this is your responsibility.”

—Dee Mirando-Gould,

Sr. Technical Director,

MorganFranklin

That's a fair criticism, says Behzad Gohari, an attorney and managing director at advisory firm Althing Group. “Financial statements are historical documents, and they are requiring forward-looking statements,” he says. “That's a little strange.”

It's a “litigation homerun,” in the view of the Institute of Management Accountants. Every business failure will be followed by lawsuits if historical financial statements didn't map out a clear path of early warning disclosures, the IMA says. “We envision a field day for the plaintiffs' bar,” the IMA wrote in its letter. “Plaintiffs would enjoy the benefit of hindsight and argue what they believe management should have known.”

Rick Day, a partner and national director of accounting at McGladrey, says FASB will have to consider putting more emphasis on requiring disclosures based on facts. “There are a lot of suggestions to clarify the amount of work management is expected to do to make these disclosures,” he says. “It should be limited to things that are known or knowable.”

Critics of the proposal also raise numerous other concerns about how and whether FASB's proposed rule can work in the real world. Jennifer Kinzel, a member of IMA's Small Business Financial and Regulatory Affairs Committee, says the subjective nature of the disclosure requirements and timing thresholds are riddled with problems. “The evaluation is very subjective,” she says. “Management is not in a position to be unbiased enough to make that assessment. What manager or owner-operator wants to admit we're operating in survival mode?”

WHAT ARE THE MAIN PROPOSALS?

Below FASB describes the main going concern proposals and how to determine if disclosures are necessary.

The proposal would provide guidance in U.S. GAAP on management's responsibilities in evaluating an organization's going concern uncertainties and on the timing, nature and extent of related footnote disclosures. An organization would determine the need for disclosures by assessing the likelihood that the organization would be unable to meet its obligations as they become due within 24 months after the financial statement date.

Going concern uncertainties would be evaluated at each interim and annual reporting period. The reporting organization would start providing footnote disclosures when it is either (1) more likely than not that the organization will be unable to meet its obligations within 12 months after the financial statement date without taking actions outside of the ordinary course of business, or (2) known or probable that the organization will be unable to meet its obligations within 24 months after the financial statement due date without taking actions outside the ordinary course of business.

Determining Whether Disclosures Are Necessary

In determining whether disclosures are necessary, the organization would assess information

about conditions and events that exist at the date the financial statements are issued (or for a private company or not-for-profit organization, the date that the financial statements are available to be issued). Mitigating conditions and events also would be considered—for example, cost cutting measures that are likely to be effective. In determining whether disclosures are necessary, however, an

organization would not consider the potential mitigating effect of management's plans that are outside of the ordinary course of business. Management's plans that involve actions of a nature, magnitude, or

frequency that are inconsistent with actions customary in carrying out an organization's ongoing business activities would be considered outside the ordinary course of business.

When the disclosure threshold is met, an organization would disclose in the footnotes:

1.The principal conditions and events that give rise to the organization's potential inability to meet its obligations

2.The possible effects those conditions and events could have on the organization

3.Management's evaluation of the significance of those conditions and events

4.Mitigating conditions and events, and

5.Management's plans that are intended to address the organization's potential inability to meet its obligations.

Disclosures may be less extensive in the early stages because available information may be limited. In subsequent reporting periods, if the organization continues to meet the disclosure threshold, disclosures would become more extensive as additional information becomes available about the previously disclosed conditions and events, and about management's plans.

Source: FASB.

Subjective Language

FASB wants companies to consider, for example, “mitigating events and conditions” as a condition for disclosure, Kinzel says. “That's way too subjective,” she says. “If you've ever been on the train with one of these companies, they'll look you in the face and say, ‘I've got this contract' or ‘the bank has promised to extend the line of credit.'” Such mitigating factors can be difficult to verify at times, she says.

Other subjective criteria and thresholds in the standard include things like “more likely than not,” the threshold for when to make disclosures about concerns over the coming 12 months, or “substantial doubt,” the trigger for public companies to consider in saying whether the entity can expect to survive. Many of the definitions for those terms come from existing accounting rules, says James Comito, a shareholder at audit firm Mayer Hoffman McCann. “Those definitions have been around forever, and people understand them, or at least they should,” he says.

The tension over the definition of subjective terms might better be described as tension over approaching a trigger, says Day. “It doesn't matter what criteria you pick,” he says. “When you get close to the bottom end of a range, there's going to be judgment involved.”

FASB also likely will have to take a second look at the exception it provides for private companies in its proposal, who would not be required to make a definitive disclosure that they have “substantial doubt” about their ability to stay in business. That requirement would exist for public companies only. “This is really the third rail in this proposal,” says Chris Smith, a partner with BDO USA. “A lot of people are trying to understand the theoretical basis for that.”

Beth Paul, a partner with PwC, says one of the firm's key concerns is that the accounting rules and the auditing rules ultimately produce requirements that are consistent, not conflicting. The Public Company Accounting Standards Board says it is watching FASB's proposal and plans to revisit its auditing rules after it see what FASB puts into effect. “If you just left the auditing standard as it was and put out this new accounting standard, they would not be aligned,” she says.