It has been, like, forever, that auditors have been issuing going concern warnings in one form or another. Back in the days when historic cost was the sole basis for measurement of assets, and authoritative “impairment” standards for taking write downs were largely non-existent, it was very understandable that auditors should be required to add qualifying language to its reports when historic cost measures were more misleading than usual.
But, although fine in concept, going concern opinions have been problematic in practice. Below are just a few reasons why:
Not gonna happen — To (loosely) paraphrase Steve Zeff, audit firms are no longer groups of licensed professionals who happen to be organized as a business; they have become customer-focused business decision makers who happen to have professional licenses. As evidence, a Bloomberg study found that auditors failed to provide a going concern qualification for 54% of the 673 largest bankruptcies between 1996 and 2002. From my own personal experience at the SEC as the S&Ls were unraveling, I documented for the chief accountant a very high frequency of auditors’ omissions of going concern language in reports on banks, even when the book value of net assets was substantially above market values.
Not timely — Empirical research has consistently shown that markets impound going concern uncertainties in stock prices before they appear in an auditor’s report. Even if an auditor should summon the courage to include going concern language, the incremental information explanatory language is negligible.
Redundant — Especially in the last 15 years or so, the staff of the SEC’s Division of Corporation Finance has done an excellent job of requiring companies to adhere to both the letter and spirit of its MD&A liquidity disclosure requirements. Consistent with the “not timely” limitation, above, the going concern disclosures by the auditor are but a faint echo of what is disclosed earlier, and with greater specificity, by management in MD&A.
Self-fulfilling prophesy — For all companies, but especially for smaller companies (both public and non-public), a going concern disclosure could be the tipping point for a key supplier: no inputs —> no production —> no sales —> bankruptcy. Even to the most conscientious of auditors, the urge to pass on making the disclosure that broke the client’s back is tough to resist. IMHO, in this day and age with a lot more current reporting and valuations taking place, it is no longer necessary (if it ever was) to put the auditor between that rock and a hard place. I can think of a lot better places to focus on for improving audit quality.
Contracting subverts appearance of auditor independence — Indeed, some companies add weight to the rock that the auditors are under by agreeing to loan covenants that trigger technical default should the auditor include going concern language in its report. I wrote about this over seven years ago, coincidentally about the time that the FASB had embarked on its going concern project. But most recently, I criticized the SEC’s chief accountant for his apparent inclination to do next-to-nothing during his tenure. If Mr. Schnurr would actually like to do something, he could write a little Staff Accounting Bulletin to require disclosure of contractual terms like these, which negatively affect the appearance of auditor independence.
Inconsistent — Any going concern disclosure trigger would be a function of the subjective likelihood of occurrence and the forecast horizon. Both criteria in use are unnecessarily vague. They lead to inconsistent interpretation and application.
After more than seven years of “due process” and a close (5 – 2) vote, the FASB issued ASU 2014-15, Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern. For the first time, management will be required to evaluate whether, as of the date the financial statements are issued, there is “substantial doubt” about the entity’s ability to exist as a going concern, and to provide certain related disclosures.
For the life of me, I can’t see how this ASU amounts to anything more than a solution in search of problem. Pick any of the problems with going concern reports that I have enumerated above, and ask yourself whether it will be abated by ASU 2014-15. Instead, the FASB has made itself into the department of redundancy; for on top of the auditor’s report and MD&A, we now have a third reporting regime. And none of them talk to each other.
Just to be sure it would not be implicated in the mess to come, the PCAOB issued a staff practice alert barely after the ink was dry on ASU 2014-15. It states that ASU 2014-15 has absolutely no effect on the auditor’s responsibilities, except to add to them. In addition to the auditor’s own reporting obligations set forth with excruciating vagueness in AU sec. 341, the auditor’s opinion must now also comprehend the issuer’s obligation to comply with ASU 2014-15. In effect, the PCAOB makes clear that the inconsistent criteria the auditor must apply to comply with auditing standards are different from the inconsistent criteria the issuer must apply to comply with U.S. GAAP.
To illustrate, consider the different probability thresholds. In complying with the FASB’s requirements “substantial doubt” about continuing as a going concern is deemed to be present “when conditions and events … indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued.” [italics supplied]
And if you need to know what “probable” means to the FASB, you can look that up in the ASC’s glossary, where it is defined as “…likely to occur.” Principles-based accounting at its best, don’t you think?
But for the purpose of the PCAOB’s AU sec. 341, “substantial doubt” can only mean “substantial doubt.” That’s because Congress, as part of a grand bargain with auditors back in 1995 (which I won’t get into here), inadvisedly added the following to the Exchange Act:
“Each audit … of the financial statements of an issuer by a registered public accounting firm shall include, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission … an evaluation of whether there is substantial doubt about the ability of the issuer to continue as a going concern during the ensuing fiscal year.” [Section 10A(a)(3), as amended by S-OX]
Evidently the PCAOB believes that it may not, like the FASB, play cutesy word games with “substantial doubt,” presumably because the term is enshrined in the law and is subject to interpretation only by the courts. Any reasonable reading of “substantial doubt” must indicate a lower probability threshold than “probable, ” which as that term has come to mean in practice is somewhere around 75% gonna happen.
Where is the SEC?
ASU 2014-15 does nothing to resolve concerns for the efficacy of going concern disclosures. It is nothing but a recipe for chaos, confusion and litigation.
Sad to say, but the issuance of ASU 2014-15 is just another example of the SEC’s abdication of any duty to promote high quality financial reporting. If this terrible terrible new requirement has been permitted to see the light of day, how can we be sure that the SEC staff is doing more than acting like paperweights as they oversee the FASB’s “due process” activities? It feels like there is nobody at the SEC possessing the authority to actually do something to help investors, and who actually cares about what investors want or need from financial statements.
The last question I’ll address is how the FASB got to the point that it would issue this terrible terrible standard. The simple and depressing answer is that this project was initiated as an IFRS convergence project. Even though convergence itself is dead and buried, the FASB must be loathe to add to the body count of dead projects. So, the FASB pressed on while the SEC stood idly by.
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Currently, the value to investors of going concern information in financial statements is approaching zero. The best solution would be to eliminate the PCAOB and FASB requirements, and to leave it to the SEC to monitor and enforce its extant MD&A disclosure requirements.
Instead, investors will have to cope with, and bear the cost of, egregious SEC and FASB dysfunction.
*I am a member of the Standing Advisory Group of the PCAOB. The views expressed herein are my own and do not necessarily reflect the views of the Board or its staff.