Going Concern

Background

Since 2017 as part of ASU 2014-15, US GAAP has required management of all companies and not-for-profit organizations to assess an entity’s ability to continue as a going concern under the requirements seen in subtopic 205-40.  Prior to ASU 2014-15, US GAAP had no specific requirements related to the going concern assessment.  The going concern assessment was, and continues to be, addressed as part of the auditing standards, which resulted in diversity in practice in the application of the going concern assessment between audited and unaudited financial statements and amongst CPA firms.  The ASU has alleviated much of that diversity in practice.

US GAAP financial statements are prepared under the presumption and basis of accounting that the entity will continue as a going concern whereby the entity will be able to meet its obligations when they become due.  The financial impact caused by the COVID-19 pandemic on certain industries and businesses has raised the question of going concern and heightened the focus on management’s assessment and adequacy of disclosures in the financial statements.  Questions have arisen regarding the requirements of the going concern assessment in US GAAP, the disclosure requirements, and the impact on the financial statements.  Such disclosures, if required, are often some of the more sensitive and judgmental disclosures in an entity’s financial statements.  However, the disclosures related to going concern and liquidity can be very important to the users of the financial statements including current and potential investors, creditors, customers, governmental agencies, etc.

Overview

The going concern standard requires management to perform an interim and annual assessment of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued (versus the balance sheet date).  Under the standard, an entity must provide certain disclosures if conditions or events raise substantial doubt about the entity’s ability to continue as a going concern.  The going concern assessment is a two-step process and described below.

Step 1

Step 1 requires management to evaluate whether events and conditions raise substantial doubt about the entity’s ability to continue as a going concern.  Substantial doubt is raised when conditions and events, considered in the aggregate, 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.  For purposes of this assessment, the term probable is used consistently with its use in Topic 450 on contingencies.  The standard notes the conditions and events an entity should consider include:

1. The entity’s current financial condition, including its liquidity sources at the date that the financial statements are issued.
2. The entity’s conditional and unconditional obligations due or anticipated within one year after the date that the financial statements are issued (regardless of whether those obligations are recognized in the entity’s financial statements).
3. The funds necessary to maintain the entity’s operations considering its current financial condition, obligations, and other expected cash flows.
4. The other conditions and events that may adversely affect the entity’s ability to meet its obligations within one year after the date that the financial statements are issued.

In addition, the standard provides the following examples of conditions or events that may raise substantial doubt about an entity’s ability to continue as a going concern:

1. Negative financial trends, for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and other adverse key financial ratios.
2. Other indications of possible financial difficulties, for example, default on loans or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, a need to restructure debt to avoid default, noncompliance with statutory capital requirements, and a need to seek new sources or methods of financing or to dispose of substantial assets.
3. Internal matters, for example, work stoppages or other labor difficulties, substantial dependence on the success of a particular project, uneconomic long-term commitments, and a need to significantly revise operations.
4. External matters, for example, legal proceedings, legislation, or similar matters that might jeopardize the entity’s ability to operate; loss of a key franchise, license, or patent; loss of a principal customer or supplier; and an uninsured or underinsured catastrophe such as a hurricane, tornado, earthquake, or flood.

If an entity concludes that there are no conditions or events that raise substantial doubt, then no disclosures on this topic are required in the financial statements and no further analysis is required.  However, if an entity concludes that there are conditions or events that raise substantial doubt, the entity then must proceed to step 2 of the analysis whereby it is required to evaluate whether it is probable that its plans will alleviate the substantial doubt.

Step 2

Step 2 requires the entity to evaluate whether its plans that are intended to mitigate the conditions or events that gave rise to substantial doubt, when implemented, will alleviate substantial doubt.  In order to conclude that management’s plans, when implemented, will alleviate substantial doubt, the standard requires the entity to demonstrate both of the following:

1. It is probable that management’s plans will be effectively implemented within one year after the date that the financial statements are issued.
2. It is probable that management’s plans, when implemented, will mitigate the relevant conditions or events that 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.

Examples of plans that may mitigate the conditions and events that raised substantial doubt include plans to (1) dispose of an asset or business, (2) borrow money or restructure debt, (3) reduce or delay expenditures, and (4) increase ownership equity.

Disclosures

If an entity identifies events or conditions that raise substantial doubt and is required to perform step 2 of the assessment, then certain disclosures will be required.  If substantial doubt is raised but is alleviated by management’s plans, disclosures should include:

• Principal conditions or events that raise substantial doubt
• Management’s evaluation of the significant of those conditions and events
• Management’s plans that alleviated the substantial doubt.

If substantial doubt is raised and is not alleviated, disclosures should include all of the items above plus a statement that there is “substantial doubt about the entity’s ability to continue as a going concern.”

Judgment must be applied in determining the extent and adequacy of the going concern related disclosures.  Entity specific facts and circumstances must be considered.  If substantial doubt is raised, but alleviated through management’s plans, the disclosure requirements do not require an explicit statement that substantial doubt was raised.  Rather, the disclosures may be able to meet the requirements without the explicit statement.  In practice, we have observed these disclosures included in the financial statements under headings such as “going concern”, “liquidity”, “risks and uncertainties”, “management’s plans”, etc.

Auditor Reporting and Other Considerations

The conclusion that substantial doubt exists and is not alleviated by management’s plans does not result in any changes to the financial statements (other than the required disclosures) or basis of presentation.  The financial statements continue to be prepared under the going concern basis of accounting.  A conclusion that substantial doubt exists and is not alleviated by management’s plans will lead to either an explanatory paragraph (for PCAOB audits) or an emphasis-of-matter paragraph (for US GAAS audits) in the auditor’s report.  In addition, the conditions and events that gave rise to substantial doubt may impact other accounting topics such as impairment of goodwill and/or long-lived assets, valuation allowances on deferred taxes or other assets, compliance with debt covenants, etc.

To better understand how the going concern standard impacts your financial statements, please contact a member of your Boulay client service team or contact us at 952.893.9320 or learnmore@BoulayGroup.com for more information.