Do you need to concern yourself with going concern in compilation and review engagements? Yes, if the financial statements are prepared in accordance with the FASB Codification. But is going concern relevant to special purpose frameworks such as the cash basis or tax basis financial statements. Yes, going concern is in play even with special purpose frameworks. This post provides an overview of what you need to know about going concern as it relates to compilation and review engagements.
A while back I wrote a post about ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, which was effective for years ending after December 15, 2016. This standard requires companies to include certain disclosures when substantial doubt is present. So, we know that financial statements prepared in accordance with GAAP must include these disclosures. Otherwise, there is a GAAP departure. And in an audit, we modify our opinion when there is a departure.
Going Concern in Compilation Engagements
But what about financial statements subject to a compilation engagement, especially when substantially all disclosures are omitted? Is it permissible for the CPA to ignore the going concern standard since it just requires disclosures? Yes, but be careful. Ask yourself whether the financial statements would be misleading (without the going concern disclosure). If they are misleading, then include a selected disclosure regarding going concern. Also, consider adding an emphasis-of-matter paragraph (regarding going concern) to your compilation report.
Consider the following scenario. Your client (who has significant going concern issues) takes your compilation report (which has no emphasis of a matter paragraph) and their financial statements (that has no disclosures) to a local bank. It’s obvious that the company is not doing well. But the bank makes a large loan anyway, and later, the company defaults on the loan. Then the bank files suit against you (the CPA) asserting that you issued the compilation report without the emphasis-of-matter paragraph and that you knew the financial statements had no going concern disclosure. The bank says the financial statements were misleading.
While the emphasis-of-matter paragraph is not required, consider adding one anyway.
Going Concern in Review Engagements
Since review engagements require full disclosure, going concern disclosures are not optional when substantial doubt exists in GAAP financial statements. They must be provided. If they are not, a GAAP departure exists.
So what going concern procedures should you perform in a review engagement?
In regard to going concern when the financial reporting framework includes going concern requirements (e.g. GAAP), AR-C 90.65 states:
If the applicable financial reporting framework includes requirements for management to evaluate the entity’s ability to continue as a goingconcern for a reasonable period of time in preparing financial statements, the accountant should perform review procedures related to the following:
Whether the going concern basis of accounting is appropriate
Management’s evaluation of whether there are conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern
If there are conditions or events that raised substantial doubt about the entity’s ability to continue as a goingconcern, management’s plans to mitigate those matters
The adequacy of the related disclosures in the financial statements
In regard to going concern when the applicable financial reporting framework does not address going concern (e.g., tax basis), AR-C 90.66 states:
If the applicable financial reporting framework does not include a requirement for management to evaluate the entity’s ability to continue as a going concern for a reasonable period of time in preparing financial statements and conditions or events that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time existed at the date of the prior period financial statements (regardless of whether the substantial doubt was alleviated by the accountant’s consideration of management’s plans) or, in the course of performing review procedures on the current period financial statements, the accountant becomes aware of conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern, the accountant should do the following:
Inquire of management whether the going concern basis of accounting is appropriate.
Inquire of management about its plans for dealing with the adverse effects of the conditions and events.
Consider the adequacy of the disclosure about such matters in the financial statements.
SSARS 24 does say that the nature and extent of procedures performed regarding going concern are a matter of professional judgment. If the audited entity has a history of profitable operations and access to financing, inquiry alone might be sufficient in a review engagement.
Going Concern Paragraph in a Review Report
If the accountant concludes that substantial doubt will remain for a reasonable period of time, an emphasis-of-matter paragraph is required in the review report. (Some reporting frameworks specify a “reasonable period of time.” For GAAP, it is one year from the date the financial statements are issued or are available to be issued.)
AR-C 90.A123 provides the following example of a going concern paragraph in a review engagement when (1) substantial doubt exists for a reasonable period of time, (2) management’s plans don’t alleviate the substantial doubt, and (3) the reporting framework requires a note disclosure.
Emphasis of Matter
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note X to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency, and has stated that substantial doubt exists about the Company’s ability to continue as a going concern. Management’s evaluation of the events and conditions and management’s plans regarding these matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our conclusion is not modified with respect to this matter.
Representation Letter in Review Engagements
Be sure to update your representation letter when performing review engagements. SSARS 24 tweaked some language in the letter and added additional wording such as the following:
Management has disclosed to the accountant all information relevant to use of the going concern assumption in the financial statements.
Special Purpose Frameworks and Going Concern
While the cash, modified cash, or tax bases of accounting do not address going concern, accountants still need to consider the effects of negative financial conditions and trends. Why? When using a special purpose framework (like the tax basis), the accountant should follow the guidance in GAAP. No, that doesn’t mean your disclosures are just like GAAP, but it does mean they are similar to GAAP.
Since GAAP tells the financial statement preparer to consider whether substantial doubt exists, then persons creating cash basis, modified cash basis or tax basis financial statements should do the same. If substantial doubt is present, going concern disclosures are necessary.
So, what is substantial doubt? The FASB Codification defines it this way:
Substantial doubt about the entity’s ability to continue as a going concern is considered to exist when aggregate conditions and events indicate that it is probable that the entity will be unable to meet obligations when due within one year of the date that the financial statements are issued or are available to be issued.
If substantial doubt is present and going concern disclosures are not included in full disclosure compilations or reviews, then modify your accountant’s report (for the departure).
Are you preparing financial statements and wondering whether you need to include going concern disclosures? Or maybe you’re the auditor, and you’re wondering if a going concern paragraph should be added to the audit opinion. You’ve heard there are new requirements for both management and auditors, but you’re not sure what they are.
This article summarizes (in one place) the new going concern accounting and auditing standards.
Going Concern Standards
For many years the going concern standards were housed in the audit standards–thus, the need for FASB to issue accounting guidance (ASU 2014-15). It makes sense that FASB created going concern disclosure guidance. After all, disclosures are an accounting issue.
Accounting Standard
ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, provides guidance in preparing financial statements. This standard was effective for years ending after December 15, 2016.
GASB Statement 56, Codification of Accounting and Financial Reporting Guidance Contained in the AICPA Statements on Auditing Standards, is the relevant going concern standard for governments. GASB 56 was issued in March 2009. (GASB 56 requires financial statement preparers to evaluate whether there is substantial doubt about a governmental entity’s ability to continue as a going concern for 12 months beyond the date of the financial statements. As you will see below, this timeframe is different from the one called for under ASU 2014-15. This post focuses on ASU 2014-15 and SAS 132.)
Meanwhile, the Auditing Standards Board issued their own going concern standard in February 2017: SAS 132.
Auditing Standard
Auditors will use SAS 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, to make going concern decisions. This SAS is effective for audits of financial statements for periods ending on or after December 15, 2017. SAS 132 amends SAS 126, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.
So, let’s take a look at how to apply ASU 2014-15 and SAS 132.
Two Stages of Going Concern Decisions
In the past, the going concern decisions were made by auditors in a single step. Now, it is helpful to think of going concern decisions in two stages:
Management decisions concerning the preparation of financial statements
Auditor decisions concerning the audit of the financial statements
First, we’ll consider management’s decisions.
Management Decisions about Going Concern
ASU 2014-15 provides guidance concerning management’s determination of whether there is substantial doubt regarding the entity’s ability to continue as a going concern.
What is Substantial Doubt?
So, how does FASB define substantial doubt?
Substantial doubt about the entity’s ability to continue as a going concern is considered to exist when aggregate conditions and events indicate that it is probable that the entity will be unable to meet obligations when due within one year of the date that the financial statements are issued or are available to be issued.
What is Probable?
So, how does management determine if “it is probable that the entity will be unable to meet obligations when due within one year”?
Probable means likely to occur.
If for example, a company expects to miss a debt service payment in the coming year, then substantial doubt exists. This initial assessment is made without regard to management’s plans to alleviate going concern conditions.
ASC 205-40-50-4 says:
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).
But what factors should management consider?
Factors to Consider
Management should consider the following factors when assessing going concern:
The reporting entity’s current financial condition, including the availability of liquid funds and access to credit
Obligations of the reporting entity due or new obligations anticipated within one year (regardless of whether they have been recognized in the financial statements)
The funds necessary to maintain operations considering the reporting entity’s current financial condition, obligations, and other expected cash flows
Other conditions or events that may affect the entity’s ability to meet its obligations
Moreover, management is to consider these factors for one year. But from what date?
Timeframe
The financial statement preparer (i.e., management or a party contracted by management) should assess going concern in light of one year from the date “the financial statements are issued or are available to be issued.”
So, if December 31, 2017, financial statements (for a nonpublic company) are available to be issued on March 15, 2017, the preparer looks forward one year from March 15, 2017. Then, the preparer asks, “Is it probable that the company will be unable to meet its obligations through March 15, 2018?” If yes, substantial doubt is present and disclosures are necessary. If no, then substantial doubt does not exist. As you would expect, the answer to this question determines whether going concern disclosures are to be made and what should be included.
Substantial Doubt Answer Determines Disclosures
If substantial doubt does not exist, then going concern disclosures are not necessary.
If substantial doubt exists, then the company needs to decide if management’s plans alleviate the going concern issue. This decision determines the disclosures to be made. The required disclosures are based upon whether:
Management’s plans alleviate the going concern issue
Management’s plans do not alleviate the going concern issue
1. What if Management’s Plans Alleviate the Going Concern Issue?
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 disclose information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the footnotes):
Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern
Management’s plans should be considered only if is it probable that they will be effectively implemented. Also, it must be probable that management’s plans will be effective in alleviating substantial doubt.
So, if management’s plans are expected to work, does the company have to explicitly state that management’s plans will alleviate substantial doubt? No.
When management’s plans alleviate substantial doubt, companies need not use the words going concern or substantial doubt in the disclosures. And as Sears discovered, it may not be wise to do so (their shares dropped 16% after using the term substantial doubt even though management had plans to alleviate the risk). Rather than using the term substantial doubt, consider describing conditions (e.g., cash flows are not sufficient to meet obligations) and management plans to alleviate substantial doubt.
Sample Note – Substantial Doubt Alleviated
An example note follows:
Note 2 – Company Conditions
The Company had losses of $4,525,123 in the year ending March 31, 2017. As of March 31, 2017, its accumulated deficit is $11,325,354.
Management believes the Company’s present cash flows will not enable it to meet its obligations for twelve months from the date these financial statements are available to be issued. However, management is working to obtain new long-term financing. It is probable that management will obtain new sources of financingthat will enable the Company to meet its obligations for the twelve-month period from the date the financial statements are available to be issued.
Notice this example does not use the words substantial doubt.
2. What if Management’s Plans Do Not Alleviate the Going Concern Issue?
If conditions or events raise substantial doubt about an entity’s ability to continue as a going concern, and substantial doubt is not alleviated after consideration of management’s plans, an entity should include a statement in the notes indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are available to be issued (or issued when applicable). Additionally, the entity should disclose information that enables users of the financial statements to understand all of the following:
Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
Sample Disclosure – Substantial Doubt Not Alleviated
An example disclosure follows:
Note 2 – Going Concern
The financial statements have been prepared on a going concern basis which assumes the Company will be able to realize its assets and discharge its liabilities in the normal course of business for the foreseeable future. The Company had losses of $1,232,555 in the current year. The Company has incurred accumulated losses of $2,891,727 as of March 31, 2017. Cash flows used in operations totaled $555,897 for the year ended March 31, 2017.
Management believes these conditions raise substantial doubt about the Company’s ability to continue as a going concern within the next twelve months from the date these financial statements are available to be issued. The ability to continue as a going concern is dependent upon profitable future operations, positive cash flows, and additional financing.
Management intends to finance operating costs over the next twelve months with existing cash on hand and loans from its directors. Management is also working to secure new bank financing. The Company’s ability to obtain the new financing is not known at this time.
Notice this note includes a statement that substantial doubt is present. Though management’s plans are disclosed, the probability of success is not provided.
ASU 2014-15 Summary
ASU 2014-15 focuses on management’s assessment regarding whether substantial doubt exists. If substantial doubt exists, then disclosures are required. Here’s a short video summarizing 2014-15:
Thus far, we’ve addressed the stage 1. management decisions. As you can see management’s considerations focus on disclosures. By contrast, auditors focus on the audit opinion. Now, let’s look at what auditors must do.
Stage 2. Auditor Decisions
SAS 132 provides guidance concerning the auditor’s consideration of an entity’s ability to continue as a going concern.
Objectives of the Auditor
SAS 132, paragraph 10, states the objectives of the auditor are as follows:
Obtain sufficient appropriate audit evidenceregarding, and to conclude on, the appropriateness of management’s use of the going concern basis of accounting, when relevant, in the preparation of the financial statements
Conclude, based on the audit evidence obtained, whether substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time exists
Evaluate the possible financial statement effects, including the adequacy of disclosure regarding the entity’s ability to continue as a going concern for a reasonable period of time
Report in accordance with this SAS
These objectives can be summarized as follows:
Conclude about whether the going concern basis of accounting is appropriate
Determine whether substantial doubt is present
Determine whether the going concern disclosures are adequate
Issue an appropriate opinion
In light of these objectives, certain audit procedures are necessary.
Risk Assessment Procedures
In the risk assessment phase of an audit, the auditor should consider whether conditions or events raise substantial doubt. In doing so, the auditor should examine any preliminary management evaluation of going concern. If such an evaluation was performed, the auditor should review it with management. If no evaluation has occurred, then the auditor should discuss with management the appropriateness of using the going concern basis of accounting (the liquidation basis of accounting is required by ASC 205-30 when the entity’s liquidation is imminent) and whether there are conditions or events that raise substantial doubt.
The auditor is to consider conditions and events that raise substantial doubt about an entity’s ability to continue as a going concern for areasonable period of time. What is a reasonable period of time? It is the period of time required by the applicable financial reporting framework or, if no such requirement exists, within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued, when applicable). The governmental accounting standards require an evaluation period of “12 months beyond the date of the financial statements.”
Auditors should consider negative financial trends or factors such as:
Working capital deficiencies
Negative cash flows from operating activities
Default on loans
A denial of trade credit from suppliers
Need to restructure debt
Need to dispose of assets
Work stoppages or other labor problems
Need to significantly revise operations
Legal problems
Loss of key customers or suppliers
Uninsured catastrophes
The need for new capital
The risk assessment procedures are a part of planning an audit. You may obtain new information as you perform the engagement.
Remaining Alert Throughout the Audit
The auditor should remain alert throughout the audit for conditions or events that raise substantial doubt. So, after the initial review of going concern issues in the planning stage, the auditor considers the impact of new information gained during the subsequent stages of the engagement.
Audit Procedures When Substantial Doubt is Present
If events or conditions do give rise to substantial doubt, then the audit procedures should include the following (SAS 132, paragraph 16.):
Requesting management to make an evaluation when management has not yet performed an evaluation
Evaluating management’s plans in relation to its going concern evaluation, with regard to whether it is probable that:
management’s plans can be effectively implemented and
the plans would mitigate the relevant conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time
When the entity has prepared a cash flow forecast, and analysis of the forecast is a significant factor in evaluating management’s plans:
evaluating the reliability of the underlying data generated to prepare the forecast and
determining whether there is adequate support for the assumptions underlying the forecast, which includes considering contradictory audit evidence
Considering whether any additional facts or information have become available since the date on which management made its evaluation
Sometimes management’s plans to alleviate substantial doubt include financial support by third parties or owner-managers (usually referred to as supporting parties).
Financial Support by Supporting Parties
When financial support is necessary to mitigate substantial doubt, the auditor should obtain audit evidence about the following:
The intent of such supporting parties to provide the necessary financial support, including written evidence of such intent, and
The ability of such supporting parties to provide the necessary financial support
If the evidence in a. is not obtained, then “management’s plans are insufficient to alleviate the determination that substantial doubt exists.”
Intent of Supporting Parties
The intent of supporting parties may be evidenced by either of the following:
Obtaining from management written evidence of a commitment from the supporting party to provide or maintain the necessary financial support (sometimes called a “support letter”)
Confirming directly with the supporting parties (confirmation may be needed if management only has oral evidence of such financial support)
If the auditor receives a support letter, he can still request a written confirmation from the supporting parties. For instance, the auditor may desire to check the validity of the support letter.
If the support comes from an owner-manager, then the written evidence can be a support letter or a written representation.
Support Letter
An example of a third party support letter (when the applicable reporting framework is FASB ASC) is as follows:
(Supporting party name) will, and has the ability to, fully support the operating, investing, and financing activities of (entity name) through at least one year and a day beyond [insert date] (the date the financial statements are issued or available for issuance, when applicable).
You can specify a date in the support letter that is later than the expected date. That way if there is a delay, you may be able to avoid updating the letter.
The auditor should not only consider the intent of the supporting parties but the ability as well.
Ability of Supporting Parties
The ability of supporting parties to provide support can be evidenced by information such as:
Proof of past funding by the supporting party
Audited financial statements of the supporting party
Bank statements and valuations of assets held by a supporting party
After examining the intent and ability of supporting parties regarding the one-year period, you might identify potential going concern problems that will occur more than one year out.
Conditions and Events After the Reasonable Period of Time
So, should an auditor inquire about conditions and events that may affect the entity’s ability to continue as a going concern beyond management’s period of evaluation (i.e., one year from the date the financial statements are available to be issued or issued, as applicable)? Yes.
Suppose an entity knows it will be unable to meet its November 15, 2018, debt balloon payment. The financial statements are available to be issued on June 15, 2017, so the reasonable period goes through June 15, 2018. But management knows it can’t make the balloon payment, and the bank has already advised that the loan will not be renewed. SAS 132 requires the auditor to inquire of management concerning their knowledge of such conditions or events.
Why? Only to determine if any potential (additional) disclosures are needed. FASB only requires the evaluation for the year following the date the financial statements are issued (or available to be issued, as applicable). Events following this one year period have no bearing on the current year going concern decisions. Nevertheless, additional disclosures may be merited.
Thus far, the requirements to evaluate the use of the going concern basis of accounting and whether substantial doubt is present have been explained. Now, let’s see what the requirements are for:
Written representations from management
Communications with those charged with governance
Documentation
Written Representations When Substantial Doubt Exists
When substantial doubt exists, the auditor should request the following written representations from management:
A description of management’s plans that are intended to mitigate substantial doubt and the probability that those plans can be effectively implemented
That the financial statements disclose all the matters relevant to the entity’s ability to continue as a going concern including conditions and events and management’s plans
Communications with Those Charged with Governance
Remember that you may need to add additional language to your communication with those charged with governance.
When conditions and events raise substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, the auditor should communicate the following (unless those charged with governance manage the entity):
Whether the conditions or events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time constitute substantial doubt
The auditor’s consideration of management’s plans
Whether management’s use of the going concern basis of accounting, when relevant, is appropriate in the preparation of the financial statements
The adequacy of related disclosures in the financial statements
The implications for the auditor’s report
Documentation Requirements
When substantial doubt exists before consideration of management’s plans, the auditor should document the following (SAS 132, paragraph 32.):
The conditions or events that led the auditor to believe that there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time.
The elements of management’s plans that the auditor considered to be particularly significant to overcomingthe conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern, if applicable.
The audit procedures performed to evaluate the significant elements of management’s plans and evidence obtained, if applicable.
The auditor’s conclusion regarding whether substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time remains or is alleviated. If substantial doubt remains, the auditor should also document the possible effects of the conditions or events on the financial statements and the adequacy of the related disclosures. If substantial doubt is alleviated, the auditor should also document the auditor’s conclusion regarding the need for, and, if applicable, the adequacy of, disclosure of the principal conditions or events that initially caused the auditor to believe there was substantial doubt and management’s plans that alleviated the substantial doubt.
The auditor’s conclusion with respect to the effects on the auditor’s report.
Opinion – Emphasis of Matter Regarding Going Concern
If the auditor concludes that there is substantial doubt concerning the company’s ability to continue as a going concern, an emphasis of a matter paragraph should be added to the opinion.
An example of a going concern paragraph is as follows:
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations, has a net capital deficiency, and has stated that substantial doubt exists about the company’s ability to continue as a going concern. Management’s evaluation of the events and conditions and management’s plans regarding these matters are also described in Note 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.
The auditor should not use conditional language regarding the existence of substantial doubt about the entity’s ability to continue as a going concern.
Opinion – Inadequate Going Concern Disclosures
Paragraph 26. of SAS 132 states that an auditor should issue a qualified opinion or an adverse opinion, as appropriate, when going concern disclosures are not adequate.
SAS 132 Summary
Now, let’s circle back to where we started and review the objectives of SAS 132.
The objectives are as follows:
Conclude about whether the going concern basis of accounting is appropriate
Determine whether substantial doubt is present
Determine whether the going concern disclosures are adequate
Issue an appropriate opinion
Conclusion
As you can see ASU 2014-15 and SAS 132 are complex. So, make sure you are using the most recent updates to your disclosure checklists and audit forms and programs.
