Regulators Eye “Going Concern” Concerns

With the economic crisis deepening, auditors and their clients get testy with each other about companies' ability to survive.
Sarah JohnsonApril 6, 2009

In the midst of an increase in the number of going-concern qualms stamped on company financials, standard-setters are working on changing how managers and auditors determine whether a business will stay viable in the foreseeable future.

It’s the one area of financial reporting where auditors are required to play forecaster. Here, they must go beyond their more comfortable role of reviewer where they retrospectively look over a company’s past financial performance.

What’s more, the prediction portion of their jobs is getting harder. That’s because the current downturn has poked holes in previously settled auditing assumptions and the capital structures of previously well-financed companies. “We all feel like we have to reprogram our crystal balls today because things are much different than they have been in the past,” said Steven Rafferty, professional practices partner at audit firm BKD LLP, during a recent meeting of the Public Company Accounting Oversight Board’s advisory group.

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In the current economic environment, Rafferty lamented, auditors’ evaluations of a company’s ability to continue as a going concern — an already “extremely subjective” task — have become evermore difficult. Further, auditors will likely have to expand their current forecasts as the PCAOB works to align its existing standard with a new rule by the Financial Accounting Standards Board requiring companies to assess their going-concern status beyond a 12-month time frame.

Last week, the PCAOB asked its advisory group for input on how to change its rule to make it more like FASB’s. Although FASB based some of its yet-to-be-issued guidelines on the PCAOB’s rule, the accounting standard-setter requires management to look out further into the future than their auditors must. The auditor regulator has been waiting for FASB’s final standard before adjusting its own rule — a concept that doesn’t sit well with some of the advisory group members, who don’t want to be restricted by the language FASB uses.

Several of them requested that the PCAOB ask FASB to hold off on issuing its new rule so that the PCAOB could revisit its standards without being restricted by the FASB’s text. “If you’re serious about the need to make changes to the auditing standard … we really need to resolve the timing of the FASB going forward with this project because you’re just going to end up creating something that doesn’t match,” said Randy Fletchall, one of the PCAOB advisers and the Americas vice chair of professional practice and risk management for Ernst & Young.FASB did not immediately respond to’s request to comment. A PCAOB spokeswoman said she had no comment.

Scheduled to be released later this month for financial periods ending on or after mid-June 2009, the new FASB rule will tell management to look ahead at least 12 months when assessing their company’s viability. But the current auditing standards tell auditors to keep their assessments to under a year from when they review a company’s financial statements.

Going-concern evaluations have been top-of-mind for the audit profession. This comes as auditors walk away from year-end reviews and the public digests the prominence of certain going-concern doubts. For instance: General Motors’ admission last month that its auditor, Deloitte & Touche, couldn’t foresee the automaker being able to last the year because of  GM’s enormous recurring losses, stockholder deficit, and inability to keep cash.

The PCAOB also warned auditors last fall that companies’ abilities to stay viable during the downturn would likely slide. Auditors, in addition, have been accused of not raising going-concern red flags for investors before companies have filed for bankruptcy protection. Past academic studies have found audit firms have made going-concern qualifications for just over half of the companies that go bankrupt, according to Joseph Carcello, a University of Tennessee professor who sits on the PCAOB’s advisory group.

Moreover, conversations between auditors and their clients have grown more contentious in recent months. “My experience this year has been that management teams and audit committees really believe we’re predicting their doom, maybe contributing to their demise,” said Ernst & Young’s  Fletchall. “[They think] the going-concern modification is truly saying they are failing and going out of business and that’s a prediction we’re making. I don’t think that’s what the standard says or that’s how we’re applying it.”

What the standard does require is that auditor consider several factors during their reviews that may tip them off to the prospect that a company won’t be in existence by the next time they do their next annual review. Among them: negative recurring operating losses, working capital deficiencies, loan defaults, unlikely prospects for more financing, and work stoppages. Auditors also consider external issues, like legal proceedings and the loss of a key customer or supplier.

If auditors aren’t satisfied by management plans to overcome such problems and stay in business — and still have “substantial doubt” about the company’s ability to stay a going concern — the auditors must explain that in their report. To be sure, with a going-concern qualification, a company may be succumbing to a “self-fulfilling prophecy,” say accounting observers. The revised status can further hinder a company on the brink of filing of Chapter 11 from avoiding bankruptcy court by giving wary investors, suppliers, and lenders a pressing need to turn away.

Audit firms issued 19 percent more going-concern opinions last year, according to data compiled by Audit Analytics that was cited by the PCAOB in a memo to its advisers. As of mid-March, more than 23 percent of filings of public-company filings made for fiscal year-ends from June 30, 2008, to December 31, 2008 included a going-concern opinion.