Andy Mintzer, CPA
According to the Financial Accounting Standards Board (FASB), under generally accepted accounting principles (GAAP), continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity’s liquidation becomes imminent. This is often referred to as the “going concern assumption”.
Why is the “going concern assumption” important?
If and when an entity’s liquidation becomes imminent, financial statements should be prepared under the liquidation basis of accounting. Finding a financial statement prepared under the liquidation basis of accounting has been said to be about as rare as a unicorn sighting. Nevertheless there is often news surrounding “going concern” issues of a particular company. This article will touch on some of the background and overarching concepts necessary to understand this important area.
Financial statements prepared using the liquidation basis of accounting present relevant information about an entity’s expectedresources in liquidation by measuring and presenting assets at the amount of the expected cash proceeds from liquidation. The entity should include in its presentation of assets any items it had not previously recognized under U.S. GAAP but that it expects to either sell in liquidation or use in settling liabilities (for example, trademarks).
Are disclosures about the entity’s ability to continue as a going concern important even if liquidation accounting is not used?
There is a generally a wide range of potential financial statement disclosures that are expected before an entity is required to adopt a liquidation basis of accounting – and it is these disclosures (or lack thereof) that financial statement readers should be on alert for.
There is substantial doubt about the entity’s ability to continue as a going concern but liquidation is not imminent.
Even if an entity’s liquidation is not imminent, there may be conditions or events that nevertheless raise substantial doubt about the entity’s ability to continue as a going concern. In those situations, financial statements should continue to be prepared under the going concern basis of accounting, but relevant conditions and events should be disclosed and described.
“We’ve got it covered”
And in fact, if conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, but the substantial doubt is alleviated as a result of consideration of management’s plans, the entity should nevertheless disclose information that enables users of the financial statements to understand (1) principal conditions or events that raised substantial doubt (2) Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, and (3) Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.
It is often misunderstood that the going concern assumption deals with the entity’s ability to “continue as a going concern“…not merely continue in business. I have heard claims that if the company can expect to keep the lights on they can avoid the disclosures about the substantial doubt to continue.
According to the FASB, ordinarily, conditions or events that raise substantial doubt about an entity’s ability to continue as a going concern relate to the entity’s ability to meet its obligations as they become due. Management’s evaluation shall be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued.
Management shall evaluate whether relevant conditions and events, considered in the aggregate, indicate that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued (for example, plans to raise capital, borrow money, restructure debt, or dispose of an asset that have been approved but that have not been fully implemented as of the date that the financial statements are issued). If these potential mitigating effects are underway – but not fully implemented – this initial evaluation cannot take them into account as described by the FASB guidance.
Going Concern Disclosures – a brief history
Prior to the issuance of ASC 2014-15 by the FASB in 2014there was no guidance in authoritative “FASB GAAP” about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related footnote disclosures.
But if you recall hearing about going concern issues before 2014 your memory is not failing you. U.S. auditing standards and federal securities law require that an auditor evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a “reasonable period of time”. Thus, the source of what financial statement preparers considered “generally accepted” had its origin in the auditing standards. As a side note this was also true for the financial statement concept of subsequent events – this accounting concept appeared in authoritative auditing literature before the FASB adopted a standard. I was a member of the AICPA’s Accounting Standard Executive Committee from 2001 through 2005 – during that time we considered a project to issue Accounting Statement of Positions to codify in authoritative GAAP some of these accounting concepts that resided in the auditing standards – that is, move the concepts to accounting literature. Before we could undertake this project, however, the FASB indicated that it would be picking up this project…which they ultimately did.
So back to the auditing standards…under these auditing standards a “reasonable period of time” was defined as a period not to exceed one year beyond the date of the financial statements being audited. So if the entity’s fiscal year is a calendar year-end – the going concern evaluation period was through the following December 31. This meant that the length of the period of time that the entity evaluated varied with the date the financial statements were issued. For example, calendar year-end financial statements issued in March had an evaluation period of time lasting about nine months – but financial statements issued in July only required an evaluation period for the remainder or the year – or about five months.
One of the ways the recent FASB authoritative GAAP standard changed the going concern evaluation is by redefining the time horizon. No longer will the time horizon be limited to one year after the date of the financial statements – the new requirement is for the horizon to generally consider whether facts and circumstance raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Thus, a calendar-year financial statement issued in June, for example, which prior to this new standard only needed to consider the time horizon through the next December 31, will not need to consider whether there are facts and circumstances which raise substantial doubt through the next twelve months. Many years ago I was involved in a matter where the entity’s financial statements were not issued until ten months after its year – thus the going concern evaluation period was comparatively short. Had this new GAAP standard been in effect the going concern evaluation period would have extended an additional ten months past the next calendar year-end.
For readers of financial statements prepared in accordance with International Financial Reporting Standards (IFRS) please consider the evaluation under those standard as “In assessing whether the going concern assumption is appropriate, management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period.”
U.S. auditing standards also require an auditor to consider the possible financial statement effects, including footnote disclosures on uncertainties about an entity’s ability to continue as a going concern for a reasonable period of time and to possibly modify its auditor’s report. The U.S. Securities and Exchange Commission (SEC) also has guidance on disclosures that it expects from an entity when an auditor’s report includes an explanatory paragraph that reflects substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. Auditing standards have evolved somewhat with the development that financial accounting frameworks, such as US GAAP, now contain authoritative accounting guidance – as a result auditing standards now look to the applicable financial reporting framework’s guidance on going concern. Auditing standards require the auditor to evaluate going concern considerations even if the financial statements are prepared under a special purpose financial reporting framework which does not have explicit going concern disclosure guidance.
Disclosures (and sometimes the lack of disclosures) about issues that raise or respond to doubt about an entity’s ability to continue as a going concern are often significant with important implications to the evaluation of the financial condition. This article touched on just some of the background as an introduction to understanding this topic.
Andrew M. Mintzer, CPA is a forensic accounting with the Los Angeles office of Hemming Morse, LLP. He is a past chair of the California Society of Certified Public Accountants.
This article discusses GAAP and professional standards in general – I have not considered any specific situations. The application of GAAP to a particular situation depends on the specific facts and circumstances and analysis of the applicable accounting standards. Therefore this article is educational in nature and does not represent professional accounting advice or services.