How Auditors Assess a Borrower’s Financial Viability

Would you like someone to tell you when there’s substantial doubt that a borrower will be able to continue normal operations over the next year? Fortunately, the going concern assumption underlies all financial reporting done under U.S. Generally Accepted Accounting Principles (GAAP). And, it’s something CPAs evaluate during financial statement audits. Here are a few items they look for during that assessment.

Warning signs

What does the term “going concern” mean? In a nutshell, a going concern entity is expected to continue to generate a positive return on its assets and meet its obligations in the ordinary course of business.

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 pending lawsuits and investigations, working capital deficiencies, negative operating cash flow, the loss of a major customer or franchise, loan defaults and debt restructurings.

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 be downgraded when uncertainties arise.

Qualified vs. unqualified

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 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 midaudit. Reasons for a disclaimer may include significant scope limitations and uncertainties within the subject company itself. Most bankers won’t accept financial statements that have this designation and will call the loan unless the borrower takes corrective action.

The assessment debate

In recent years, regulators, businesses, auditors and other stakeholders have debated how to reduce diversity in financial reporting about going concern issues. A new FASB standard goes into effect for annual periods ending after December 15, 2016, that requires management, not auditors, to make the going concern assessment. The purpose of using company insiders to make this assessment is to identify red flags earlier and with greater accuracy. The new standard doesn’t eliminate an auditor’s responsibility to review management’s going concern assessment, however. Auditors must still scrutinize management’s assessment to ensure timely, relevant disclosure of potential uncertainty.

The value of audits

Whether the opinion is unqualified, qualified or adverse, audit opinions can offer important clues as to whether companies will continue to operate as going concerns. If you have questions about a borrower’s future viability, contact a CPA advisor for assistance conducting additional due diligence.

For more information on Smith and Howard’s commercial banking services, please contact Paul Atkinson at 404-874-6244.