The Financial Accounting Standards Board on October 9, issued two proposed statements of financial accounting standards (exposure drafts) that may become more relevant as the credit crisis continues. One deals with the circumstances under which a reporting entity must acknowledge that its status as a “going concern” is in doubt, and the other addresses the issue of how events occurring subsequent to a balance sheet date are to be accounted for. Neither exposure draft provides radically different information from existing guidance, but instead, seeks to clarify and codify the standards that have historically been applied to these issues.
The exposure draft entitled “Going Concern” aptly noted that when preparing financial statements management should assess the reporting entity’s ability to continue as a going concern. It directs company officials to file results on a going concern basis unless management (1) intends to liquidate the entity or cease operations, or (2) has no “realistic alternative” but to do so.
In assessing whether the going concern assumption (on which financial statements are prepared) is appropriate, management must take into account all available information about the future — which is defined as at least 12 months from the end of the reporting period. In this regard, management may identify information about certain “conditions or events” that, if considered in the aggregate, indicate there could be “substantial doubt” about the reporting entity’s ability to continue as a going concern. These conditions or events include:
“Negative trends,” such as recurring operating losses, working capital deficiencies, negative cash flow from operating activities, and adverse key financial ratios;
“Indications of financial difficulties,” such as default on loans or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, non-compliance with statutory capital requirements, and a need to seek new sources or methods of financing or to dispose of significant assets;
“Internal matters,” such as work stoppages, substantial dependence on the success of a particular project, uneconomic long-term commitments, and a need to significantly revise operations;
“External matters,” such as legal proceedings, legislation, loss of a key franchise, license, or patent, loss of a principal customer or supplier, and an un-insured or under-insured catastrophe.
If, after considering the information in the aggregate, management believes there is substantial doubt about the entity’s ability to continue as a going concern, management is instructed to consider its plans, if any, for dealing with the adverse effects of those conditions and events. In addition, management must decide whether the plans will mitigate the adverse effects, and can be effectively implemented.
The draft states that in cases where management is aware of “material uncertainties” about events or conditions that may cast substantial doubt on the entity’s ability to continue as a going concern, the company should disclose those uncertainties. Moreover, when an company does not — in light of the existence of such material uncertainties — prepare its financial statements on a going concern basis, it should disclose this fact, as well as the basis on which the financial statements were prepared.
Further, as a result of current economic conditions, there likely will be an increase in the number of “going concern” opinions auditors will be issuing. Indeed, it is generally believed that the issuance of such an opinion is, as a practical matter, a self-fulfilling prophecy. An entity receiving such an opinion will almost always be denied access to credit at the same time that the investment community shuns its stock.
Subsequent events are events or transactions that occur after the balance sheet date, but before the date on which financial statements are issued or “available to be issued.” The second exposure FASB issued, entitled “Subsequent Events,” says that there are two distinct types of subsequent events. The first variety encompasses events or transactions that provide additional evidence about conditions that existed as of the date listed on the balance sheet. These subsequent events are identified as “recognized subsequent events.”
The second variety includes events that provide evidence about circumstances that did not exist at the date of the balance sheet, but instead arose subsequent to that date. These subsequent events are referred to as “non-recognized subsequent events.” For this purpose, financial statements are regarded as “issued” when they are widely-distributed to users for general use and reliance in a form and format that complies with generally accepted accounting principles (GAAP).
By contrast, financial statements are “available to be issued” when they are complete in a form and format that complies with GAAP, and all approvals necessary for issuance have been obtained. According to the exposure draft, a company that has an “historical practice” or “current expectation” of widely distributing its financial statements shall examine subsequent events through the date the financial statements are issued. All other reporting entities shall examine such events through the date on which the statements are available to be issued.
A company should recognize its financial statements the effects of all subsequent events that provide additional evidence about conditions that existed at the date of the balance sheet. For example, recognized subsequent events might include the settlement of a lawsuit in which the events that gave rise to the litigation had taken place before the balance sheet date. Another example of a recognized subsequent event would be a loss on an uncollectible account receivable as a result of a customer’s deteriorating financial condition that led to bankruptcy after the balance sheet date. In such a case, the bankruptcy filing represents the culmination of conditions that existed over a “relatively long period of time,” as noted in the exposure draft.
In contrast, a company should not recognize subsequent events that provide additional evidence about conditions that did not exist at the date of the balance sheet, but instead arose subsequent to that date. Examples of non-recognized subsequent events include, the sale of a bond or common stock issuance after the balance sheet date. It also may include business combination that occurs after the balance sheet date, or a loss of plant or inventories as a result of a natural disaster that occurred after the balance sheet date.
Although these non-recognized subsequent events are not recognized in the financial statements, they may be of such significance that their disclosure is required. Moreover, the exposure draft provides that, occasionally, a non-recognized subsequent event “may be so significant” that disclosure thereof can “best be made” by means of pro-forma financial data, which would supplement the historical financial statements.
Once they are approved as accounting standards, both exposure drafts will be effective for interim or annual financial periods ending after the rule codification, and will be applied prospectively. Nevertheless, as a practical matter, we fully expect the principles ingrained in these pronouncements to be applied without delay.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.