Substantial doubt and going concern. These are phrases management does not like to hear from an auditor. A common response when these phrases arise is: What does substantial doubt mean, and why would my company want to be a going concern?
Whether presented together or separately, each of these phrases can sound ominous. Why are they important? Does management have to take them into account?
The answer is yes. Accepted auditing standards require management to assess an entity’s ability to continue as a going concern for each reporting period. The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-15, Presentation of Financial Statements – Going Concern, which established Accounting Standards Codification (ASC) 205-40, Going Concern specifically to align management’s responsibilities with U.S. auditing standards.
In the past, the only responsibility for discussing substantial doubt of a going concern lied with auditors, who were responsible for raising with management any issues that raised substantial doubt of a going concern. A new standard adopted in 2017, however, now requires management to do its own assessment and to discuss this assessment with their auditors.
Let’s break down the standard and delve into management’s responsibility.
What is the standard for substantial doubt?
When conditions and events, considered in aggregate, indicate that it is probable (i.e., likely to occur) that the entity will be unable to meet its obligations as they become due, the standard for substantial doubt comes into play. The time frame is within one year of the date the financial statements are issued or, when applicable the date the financial statements are available to be issued. When an auditor is involved, this is an important concept because the financial statements are not considered issued until the audit report has been issued as well. As a result, the assessment usually is done on the audit report date.
The assessment typically includes analyzing working capital, current operating expenses and current debt, or debt that will become current and due within a year of issue of the audit report, not the balance sheet date.
Another key element for management to keep an eye on is cash flows from operations, which is presented on the statement of cash flows. Any negative cash flows from operations could be a red flag for the entity’s ability to continue as a going concern. If conditions exist that raise questions about the company’s liquidity or ability to pay off debt as it becomes due, these conditions should lead to questions about whether they create substantial doubt about the company’s ability to continue as a going concern.
Unless substantial doubt exists, continuation of an entity as a going concern is presumed as the basis for financial reporting. When substantial doubt does exist, one of two outcomes will occur. Either management will have plans to alleviate the substantial doubt and those plans will reasonably succeed, or management’s plans will not alleviate the substantial doubt.
For either outcome, management’s plans will be disclosed. If it is probable that substantial doubt can be alleviated through management’s plan, then management will disclose the going concern indicators and explain the plan that alleviates substantial doubt in the notes in the financial statements. If it is not probable that substantial doubt can be alleviated, then management will disclose the going concern indicators and management’s plans in the notes to the financial statements. In addition, an emphasis of a matter paragraph is added to the audit opinion referencing the note in the financial statements.
There may be other effects of reporting debt or other commitments as a result of raising substantial doubt of continuing as a going concern. This depends on the company’s debt or equity situation. In severe situations in which liquidation is imminent, the company will have to report its financial statements under the liquidation basis of accounting instead of under a going concern basis.
In 2020, the confluence of several negative events affecting the oil and gas industry has led many oil and gas companies to consider whether there is substantial doubt about their ability to continue as a going concern for the following year. To determine whether a Company has substantial doubt of continuing as a going concern, the Company must assess whether there are events or conditions that raise substantial doubt.
For oil and gas companies, COVID-19 and the severe drop in oil prices should be considered events that can raise substantial doubt. For companies where substantial doubt is raised, management must determine a plan for the future and whether that plan can alleviate substantial doubt of a going concern.
Many companies have already made substantial efforts to alleviate any doubt through pay cuts, lay-offs or furloughs, reduction in spending budgets, access to other sources of funding or consolidation with similarly structured companies. What plans has your company determined and implemented to alleviate substantial doubt?
For questions about substantial doubt in the audit process, contact us. We are here to help.