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LCD Deep Dive: No longer just for auditors, ‘going concern’ warnings are emerging with greater frequency

With the economy officially in recession, the "going concern warning" is popping up with some regularity in quarterly financial filings. But in the aftermath of the Great Recession, the warning's rules have been altered in a way that can cause it to arrive earlier than before, and possibly with greater frequency, yet with no less potency.

A going concern warning is issued by a company's management or auditors — or both — when they believe that within the upcoming 12 months from the date of the report "it is probable" the company will not have the liquidity to pay its obligations as they come due, or will violate a debt covenant.

An attorney with a background at the Securities and Exchange Commission suggests probable equates to likely and implies "a greater probability than 51%, probably closer to a range of 70% to 80% that it will happen."

In such a circumstance, the warning sentence penned to investors is roughly, "There is substantial doubt that the company can remain a going concern over the next twelve months." Hence the term, going concern warning. It is sometimes also referred to as substantial doubt.

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What's different this time

Why might going concern warnings come about earlier, and perhaps more often, than in 2008–09? What has changed?

Key rules around going concern warnings were modified 3.5 years ago, beginning with year-end financials dated after Dec. 15, 2016.

Before year-end 2016, company auditors alone bore responsibility to warn investors of that company's potential inability to pay its debts, or an impending covenant default, during the upcoming year. Management and its internal accountants had no role in the process. In fact, even while performing reviews on interim (i.e., not year-end) financial information, company auditors had no obligation to flag a potential default.

Since auditors only formally reported on full-year performance, the warnings, when they came, were found in their reports written in conjunction with year-end financial statement audits. This means that, during the Great Recession, going concern warnings were generated around the time Form 10-Ks and other annual financial reports were being produced, and not during the balance of the year.

That changed beginning with year-end 2016 financial statements. The Financial Accounting Standards Board issued Accounting Standards Update 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40), or ASC 205-40 for short, specifically assigning responsibility to managements and their internal accountants for warning investors of impending trouble.

In FASB's words, "an entity's management should evaluate whether there are conditions or events, considered in the aggregate, 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" (emphasis in original).

Management's legal requirement to assess its company's prospects over the subsequent year following the release date of the financials is the new news. Nothing changed for auditors — they retained their obligation to warn. But now management was affirmatively on the hook to issue the warning, as well, during each quarter's financial review.

For clarity, ASC 205-40 went on to define when substantial doubt about an entity's survival exists, as being "when relevant conditions or events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due" (emphasis added).

Under ASC 205-40, when management determines there is substantial doubt about corporate survival, they must place the warning language "in the footnotes" of public filings. While anywhere within the filing is fair game, according to Stan Manoukian, analyst at Independent Credit Research LLC, it is often found in the liquidity section of the Management Discussion & Analysis section. He notes that it might also be in Management Discussion & Analysis' introductory paragraphs, in a discussion of risk factors, in any other section, or on its own. The key thing is that the warning appears.

Auditors still on the hook

Even with ASC 205-40 implemented, public company auditors are still required to determine if there is a going concern issue. One of the principle documents providing guidance to them on these matters is the Public Company Accounting Oversight Board's AU 341 (The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern).

The document requires auditors to probe managements, expecting to be presented with a fair assessment of the company's future prospects, informed of events and conditions that might cause financials to deteriorate, and shown management's plans to address and counter the negative issues.

Management complies with its auditor's needs by using information at their disposal as of the date the statements are issued, taking into account potential operating losses, labor difficulties, legal issues, debt covenants, and anything and everything else that could go wrong.

If the auditors believe the evidence points to substantial doubt, management needs to provide them with their plans to mitigate the causes of the substantial doubt, and assess those plans' odds of success. After weighing all the information, the auditors would then conclude whether substantial doubt still exists.

At the same time, ASC 205-40 directs management, using the same data provided to auditors, to disclose to investors its own assessment of whether substantial doubt exists for the upcoming 12 months, and how it plans to alleviate it. It must provide the "substantial doubt … going concern" warning if its plans do not resolve the potential trouble. And even if its plans do resolve the issues, their existence — and planned resolution — must be reported to investors, as well.

Management-driven solvency warnings use precisely the same "substantial doubt … going concern" language as the auditor-only version used before December 2016. But investors have sometimes differentiated between management's warning and an auditor's warning, even occasionally taking to calling the management version substantial doubt, and the auditor version going concern.

A former audit partner at a Big Four accounting firm categorizes the distinction as "two sides of the same coin," adding that it would be "making a distinction where there is no difference."

That is, they mean the same thing.

This story was written by Jack Hersch, who covers distressed debt for LCD.

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