fasb’s proposal for going concern uncertainties: a new layer of accounting guidance for management

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The FASB’s latest proposal on going concern uncertainties introduces a new layer of accounting guidance that adds to the existing requirements set by auditing standards and SEC regulations. The proposed new guidance responds to a wave of unwelcome surprises, as scores of companies faced unexpected liquidity problems during an economic downturn that adversely affected businesses while the FASB’s previous (2008) proposal was sidetracked by other priorities. The added guidance may not eliminate these kinds of surprises altogether, but it provides a more systematic approach that is designed to promote more consistency in the nature and timing of disclosures about an entity’s ability to continue as a going concern. This Messenger summarizes the proposal, along with the questions, suggestions, and concerns cited in comment letters.

The proposed approach

The FASB’s proposed approach describes how management should evaluate going concern uncertainties and what information should be provided in the footnotes to the financial statements. The proposal introduces new definitions and disclosure thresholds, along with scalable reporting requirements that would allow the disclosures to evolve as the level of financial stress increases. These requirements

October 2013

FASB’s Proposal for Going Concern Uncertainties: A New Layer of Accounting Guidance for Management

generally would apply to all entities that use US GAAP, though some disclosures would apply only to SEC filers that use US GAAP.

Below is an overview of the steps that would be required under the new approach.

1. Determine if the entity is required to use the liquidation basis of accounting. There is an inherent presumption under US GAAP that the reporting entity will be able to continue as a going concern. The proposed guidance would define a “going concern” as an entity that will continue to operate by realizing its assets and meeting its liabilities in the ordinary course of business. If this is not the case and liquidation is considered imminent, then the entity would use the liquidation basis of accounting instead, starting when certain events occur. Our Substance of the Standard on “FASB Finalizes Standard on Liquidation Basis of Accounting” provides more details on when and how this basis should be applied. (http://www.mhmcpa.com/Portals/0/PDF/Substance/SoS-FASB-Finalizes-Standard-on-Liquidation-Basis-of-Accounting.pdf)

2. Determine whether going concern disclosures are necessary. At each annual and interim reporting date, management would assess the risk that the entity may not be able to meet its obligations as they come due within 24 months after the financial statement date. This assessment would consider all the information about conditions and events that exist at the

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date the financial statements are issued (or for a nonpublic entity the date the financial statements are available to be issued). Examples of relevant information are provided in the Appendix to this Messenger. For purposes of this step, the guidance would not permit consideration of the mitigating effects of any of management’s plans that are outside the ordinary course of business. Disclosures would be required if the answer is yes to either of the following two questions.

a. Is it more likely than not that the entity will be unable to meet its obligations within 12 months after the financial statement date without taking actions outside the ordinary course of business?

b. Is it known or probable that the entity will be unable to meet its obligations within 24 months after the financial statement date without taking actions outside the ordinary course of business?

3. Provide the required going concern disclosures. If Step 2 indicates that disclosures are necessary, the disclosures would need to provide information that enables users of the financial statements to understand all of the following:

a. The principal conditions and events that give rise to the entity’s potential inability to meet its obligations.

b. The possible effects that those conditions and events could have on the entity.

c. Management’s evaluation of the significance of those conditions and events.

d. Mitigating conditions and events.

e. Management’s plans that are intended to address the entity’s potential inability to meet its obligations.

4. For SEC filers, determine if there is substantial doubt about the going concern presumption. The determination of substantial doubt would be similar in scope to the determination in step 2 in that it would encompass events and conditions of the types listed in Tables 1 and 2 of the Appendix to this Messenger. But this step would differ from step 2 in that it would permit consideration of the effects of all of management’s plans that are likely to be effectively implemented and that are likely to mitigate the adverse conditions and events, including the mitigating effect of management’s plans that are outside the ordinary course of business.

5. If there is substantial doubt, provide the required disclosures for the SEC filer. When Step 4 indicates that disclosures about substantial doubt are necessary for an SEC filer, the disclosures would need to specifically state that there is substantial doubt through the use of the phrase “there is substantial doubt about the entity’s ability to continue as a going concern within 24 months after the financial statement date” or similar wording that includes the terms “substantial doubt” and “ability to continue as a going concern” or “ability to prepare financial statements under the going concern presumption.”

Some of these steps introduce inconsistencies with the existing US auditing standards and with IFRS. Other standard-setters may consider changes in this area in the future. Currently, the PCAOB is considering a proposal that would expand the audit report for public companies to include a section on “critical audit matters” where the auditor can provide additional insights into the most challenging audit issues, including the auditor’s conclusions regarding going concern matters. See MHM Messenger 17-13

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(http://www.mhmcpa.com/articles/vw/1/itemid/438.aspx) for more details of the PCAOB’s proposal. The PCAOB has indicated it may consider other changes related to going concern after the FASB completes its project.

A summary of key differences from current IFRS standards, US auditing standards, and SEC regulations is provided in Table 3 of the Appendix to this Messenger.

Open questions and concerns

The FASB’s proposal was approved by a divided Board in January 2013, with two Board members dissenting. The exposure draft indicates the dissenting members had concerns that: (a) the two separate disclosure thresholds in Step 2 would be too difficult to implement and audit, and (b) the proposal would not represent an improvement over current reporting requirements for SEC filers. The comment letters expressed similar concerns.

Below are highlights of some of the major themes expressed in the comment letters.

• Complexityandpracticalityofscalabledisclosures. Many commentators expressed concerns about added complexity, especially with regard to the scalable disclosures that would introduce a more-likely-than-not disclosure threshold. Accountants are familiar with the application of a “more-likely-than-not” criterion to specific transactions or specific line items on financial statements. But this degree of precision could prove more challenging to apply to the overall state of the entity. Because the term “more likely than not” is defined in US GAAP as a likelihood of greater than 50 percent, the determination could involve “close calls” regarding whether an entity is able to continue as a going concern or not.

• Legal implications. The proposal would have legal implications because it would result in the movement of certain forward-looking statements from the MD&A (where the statements are covered by legal safe harbors) to the footnotes (where they are not covered by safe harbors). This would expand the legal liability for companies, management, boards of directors, and auditors. There are risks that it might lead to second-guessing in shareholder litigation, auditor inspection findings, and regulatory enforcement actions for SEC filers that issue quarterly financial statements, thereby putting public companies at a disadvantage compared with non-filers that do not issue interim financial statements.

• Other unintended consequences. The proposed footnote disclosure requirements might have other unintended consequences for private companies as well, such as providing sensitive information that would cut off their access to loans and constitute a self-fulfilling prophecy of defeat. The requirements might also have unforeseen consequences for public companies, such as promoting disclosure overload and boilerplate disclosures instead of information that investors find helpful for decision-making.

Diverse views on desirable changes

The comment letters reflect diverse schools of thought regarding the changes that are needed to the FASB’s 2013 proposal. The key points made in the letters include the following suggestions.

1. Just incorporate the existing guidance inauditing standards. To avoid the potential legal implications and other unintended consequences, some accountants believe the FASB should limit its guidance to a simple codification of the requirements of the existing US auditing standards, rather than add a new layer of accounting guidance that requires forward-looking statements in footnotes to financial statements. Some suggest

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TheinformationinthisMHMMessengerisabriefsummaryandmaynotincludeallthedetailsrelevanttoyoursituation.PleasecontactyourMHMauditortofurtherdiscusstheimpactonyourauditorauditreport.

the Board should defer to the SEC to set the disclosure requirements for SEC filers, and any changes needed to promote consistency of disclosures across public and private companies might best be handled through an update to the required disclosures regarding business risks and uncertainties, rather than creating a new set of going concern disclosures.

2. Addflexibilityfor“closecalls.” Other accountants believe the FASB’s approach could be helpful, but they say the scalable disclosure requirements need to be modified so they are less challenging to apply. One way to do this might be to shorten the time horizon. Another way might be to redefine the more-likely-than-not disclosure threshold as a range, so that management and auditors can more effectively consider all the factors, both qualitative and quantitative, before an entity reaches the stage where there is substantial doubt about its ability to continue as a going concern.

3. Require substantial doubt disclosures for allentities. Some accountants believe the substantial doubt disclosures should apply to both SEC filers and other entities for greater consistency with current requirements of the existing US auditing standards. The letters say the FASB’s basis for conclusions does not adequately explain why there are different standards for SEC filers and other entities.

4. Issueconcurrentlywithupdatedauditingstandards.Almost all respondents to the exposure draft mentioned potential problems associated with the interaction of the FASB’s proposal with existing US auditing standards and/or international accounting standards. Although other standard-setters have said they may consider changes in response to

the FASB’s proposal, most accountants seem to be concerned about the need for coordination and a smooth resolution of any inconsistencies prior to the effective date. A common theme is that the FASB’s guidance should be issued concurrently with revised auditing standards.

5. Provide additional clarification. Some letters request more guidance or clarification in certain areas. For example, in our letter, MHM requested more guidance to clarify the meaning of management plans that are in the “ordinary course of business.” Other letters suggest the footnote disclosures should be limited to factual information that can be supported and verified, rather than a discussion of possible future events.

For more information

MHM’s Professional Standards Group will continue to monitor progress on the FASB’s and related proposals on going concern issues. Our comment letter is available on the FASB’s website. If you would like additional information about the proposed changes, please contact Ernie Baugh of MHM’s Professional Standards Group or your MHM service professional. You can reach Ernie at [email protected] or 423-870-0511.

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MHM Messenger 18-13 Appendix: FASB’s Proposal for Going Concern Uncertainties

Relevant Conditions and Events to be Evaluated When Assessing an Entity’s Ability to Continue as a Going Concern

Table 1. Relevant Conditions and Events

Under the FASB’s 2013 proposal on going concern uncertainties, the conditions and events to be considered in the going concern assessment would include the following:

a. Sources of liquidity, including available liquid funds and available access to credit.

b. Funds necessary to maintain operations in the ordinary course of business.

c. Conditional and unconditional obligations due or anticipated within 24 months after the financial statement date.

d. Conditions and events that could adversely affect the entity’s ability to meet its obligations. Examples: the anticipated loss of a major customer, the impending maturity of significant debt, or the upcoming expiration of a key patent. See Table 2 for more examples.

e. Conditions and events that could mitigate the entity’s potential inability to meet its obligations. Examples: the recent renewal of a major customer contract, a reduction in the costs of raw materials, or an increase in market demand for the entity’s products.

f. The effect of management’s plans that are in the ordinary course of business. Those plans that are deemed to be within the ordinary course of business shall be considered only if they are likely to be effectively implemented and likely to mitigate the adverse conditions and events.

Table 2. Examples of Adverse Conditions

The following are additional examples of the adverse conditions and events mentioned above (in part d of Table 1) that may result in an entity’s potential inability to meet its obligations.

a. Negative trends, for example, recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and adverse key financial ratios.

b. Other indications of possible financial difficulties, for example, default on loans or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring 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 .

c. 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.

d. External matters that have occurred, 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.

Note: The determination of whether there is substantial doubt and disclosures are necessary would depend on an assessment of all information about conditions and events in the aggregate, including mitigating conditions and events. The existence of one or more of the above conditions would not necessarily indicate that there is substantial doubt about the entity’s going concern presumption. Similarly, the absence of those conditions would not necessarily indicate that substantial doubt does not exist.

Summary of Key Differences with Other Standards and Regulations

Table 3. Comparison with IFRS, Existing US Auditing Standards and SEC Regulations

Highlights of the main similarities and differences between the current guidance and the existing IFRS standards, SEC regulations, and auditing standards, are as follows.

A. Comparison with IFRS

The requirements for IFRS differ in several respects from the FASB’s proposal. However, the IASB is in the process of clarifying the requirements for IFRS and may make changes as part of that process.

Current differences with the FASB’s proposal include: (1) IFRS does not provide guidance on the liquidation basis of accounting. Instead, it simply requires that the reporting entity disclose the basis of preparation used. (2) IFRS uses a single threshold for disclosures of going concern uncertainties instead of the two proposed by the FASB. (3) IFRS sets a minimum for the period of time to be evaluated (12 months from the date of the financial statements), but it does not limit the period of time to be evaluated to 24 months from the date of the financial statements as the FASB’s proposal does.

B. Comparison with US auditing standards

The current US auditing literature requires that auditors assess the possible financial statement effects of uncertainties about an entity’s ability to continue as a going concern. The FASB’s proposal would introduce several changes, including the following:

• Morefrequentassessmentsforcompaniesthatissueinterimfinancialstatements. Existing auditing standards require that audit reports reflect an evaluation of management’s assumption about a company’s ability to continue as a going concern. But audit reports are typically issued only once a year. The FASB’s proposed guidance would require assessments by management for interim as well as annual periods. This could result in more timely disclosures for investors and other users of financial statements.

• Longerhorizonforassessments. Current auditing standards require that the auditor’s report highlight material going concern uncertainties, meaning when there is substantial doubt about the entity’s ability to continue as a going concern for a “reasonable period of time.” The term “reasonable period of time” is defined as a period not to exceed one year beyond the date of the financial statements being audited. The “basis for conclusions” section of the FASB’s proposal indicates the Board decided to extend that period of time to accommodate current practice. The FASB’s research indicates that some entities voluntarily disclose in the footnotes going concern uncertainties that go beyond one year.

• Scalablehorizon-baseddisclosurethresholds. The FASB’s proposal attempts to bridge the gap in the assessment periods between auditing standards and certain current practices by setting scalable horizon-based disclosure thresholds. These thresholds use more stringent probability thresholds for the later stages of the assessment period, (i.e., the trigger for required disclosures in Step 2 is when it is “more likely than not” the entity will be unable to meet its obligations in the first 12 months following the financial statement date, while the threshold increases to “probable” when the horizon extends to the full 24 months following the financial statement date).


Table 3. Comparison with IFRS, Existing US Auditing Standards and SEC Regulations

C. Comparison with SEC rules

The FASB’s proposed changes are not intended to expand upon the requirements of current SEC rules. But the FASB expects its guidance would result in more consistency in the nature and timing of footnote disclosures for all entities, including SEC filers as well as private companies and not-for-profit entities.

Currently, SEC filers are required to discuss factors related to going concern issues in the sections of their reports on the MD&A and risk factors.

• MD&A. Item 303(a) of Regulation S-K requires that SEC registrants disclose in the Management Discussion & Analysis (MD&A) sections of their annual reports on Form 10-K information about trends and uncertainties that are reasonably likely to have a material effect on the registrant’s liquidity, capital resources, and results of operations.

• RiskFactors. Item 503(c) of Regulation S-K requires the disclosure of risk factors that can help users of financial statements with their evaluation of going concern uncertainties.

In practice, it seems feasible that the addition of a new layer of requirements in US GAAP would result in a tiered approach to disclosures for SEC filers. The financial statement disclosures would contain the significant conditions and events described in the FASB’s guidance, while the MD&A and risk factors would provide more information about the potential causes and effects of going concern uncertainties.
