“Going Concern” Concerns

CPAs reconsider the “going concern” assumption every time they audit financial statements. When the long-term viability of a borrower is doubtful, it may cause the CPA to issue a qualified audit opinion — or, worse, to withdraw from the job altogether.

Financial statements are generally prepared with an assumption that the business will remain a going concern. That is, the entity is expected to continue to generate a positive return on its assets and meet its obligations in the ordinary course of business.

How do viability concerns affect financial statements?

Sometimes auditors discover adverse conditions and events that cast substantial doubt on the entity’s ability to continue as a going concern over the next year. Possible red flags include:

• Working capital deficiencies,
• Negative operating cash flow,
• Loan defaults and debt restructurings,
• Labor union conflicts and work stoppages, and
• Pending lawsuits and investigations.

When auditors reject the going concern assumption, they may adjust balance sheet values to liquidation values, rather than historic costs. Footnotes also may report going concern issues. And the auditor’s opinion letter — which serves as a cover letter to the financial statements — may downgrade when uncertainties arise.

What does an audit opinion mean?

Audit opinions vary depending on available information, financial viability, errors discovered during audit procedures and other limiting factors. The cleanest, most desirable type of audit opinion is an “unqualified” one. Here the auditor states that the company’s financial condition, position and operations are fairly presented in the financial statements.

When uncertainties exist regarding the going concern assumption, the auditor will typically issue a “qualified” opinion and disclose the nature of these uncertainties in the footnotes. An auditor may also issue a qualified opinion if the financial statements appear to contain a small deviation from Generally Accepted Accounting Principles (GAAP), but are otherwise fairly presented — or if the borrower limits the scope of audit procedures.

Much less desirable are “adverse” opinions. These indicate that there are material exceptions to GAAP that affect the financial statements as a whole.

By far the most alarming opinion is a disclaimer. It occurs when an auditor gives up mid-audit. Reasons for a disclaimer may include significant scope limitations and uncertainties within the subject company itself. Most lenders won’t accept financial statements that have this designation and will call the loan unless the borrower takes corrective action.

What’s the significance of an auditor switch?

Before even starting fieldwork, some auditors will pull the plug on long-term audit clients if they suspect the need to issue a disclaimer or an adverse opinion. Or sometimes it’s the client that replaces their auditors if they start to question long-term viability.

Regardless of who initiated the switch, a sudden, unexpected change of auditors could forewarn of going concern issues.

What’s the future of going concern assessments?

For the last five years, regulators, businesses, auditors and other stakeholders have debated how to reduce diversity in financial reporting about going concern issues. Last summer, the Financial Accounting Standards Board (FASB) proposed a controversial change to GAAP that would require a longer assessment period and mandate more frequent going concern assessments.

In March, FASB voted to support a watered-down recommendation that maintains the “substantial doubt” threshold and the current assessment period of one year beyond the financial statement date. FASB’s proposed changes move the guidance on going concern assessments from auditing standards to GAAP. So, management (not external auditors) could be responsible for evaluating and disclosing going concern uncertainties in the future.

Expect a final standard or a revised proposal on going concern assessments later this year. In fact, it may have even happened by the time you’re reading this. Consult with an accounting professional for the latest information on going concern assessments.

How can lenders monitor viability?

In the meantime, lenders should pay attention to audit opinion letters. The type of opinion expressed may have serious implications about your borrower’s ability to operate as a going concern. Downgraded opinions warrant your immediate attention. For more information, contact Sean Taylor, Paul Atkinson, Marvin Willis or Sean Spitzer in our Assurance Services Group at 404-874-6244, or you can contact us online.