How Clear Is Your Crystal Ball?
Current auditing rules require auditors to consider several factors during their reviews that may tip them off to the prospect that a company won’t be in existence by the next time they do their next annual review. Among them: negative recurring operating losses, working capital deficiencies, loan defaults, unlikely prospects for more financing, and work stoppages. Auditors also consider external issues, like legal proceedings and the loss of a key customer or supplier.
If there’s potential doubt about a company’s going-concern status, the audit firm is expected to talk to management about how they plan to keep the company afloat — such as by selling off noncritical assets — and the feasibility of such plans. If, after assessing management’s strategies, the auditors still have “substantial doubt” about the company’s ability to stay a going concern, they will explain that in their report. Otherwise, without a going-concern qualification, auditors “presume you will stay in business,” explains Lynda Dennis, an accounting instructor at the University of Central Florida who is also a former auditor and former CFO of a regional YMCA.
To be sure, with a going-concern qualification, a company may be succumbing to a “self-fulfilling prophecy,” say accounting observers. The revised status can further hinder a company on the brink of filing of Chapter 11 from avoiding bankruptcy court as the qualification gives wary investors, suppliers, and lenders a pressing need to turn away.
Through one of its rare practice alerts in December, the Public Company Accounting Oversight Board warned the audit firms to pay attention to high-risk areas for fraud and mistakes during their reviews of financial statements prepared amid the financial downturn. Among the board’s reminders was the particular challenge some companies may face to remain viable during a time when many companies’ access to financing has decreased and the number of delayed payments has increased. At the time, PCAOB chief auditor Tom Ray, who has since announced he is leaving the board this month, predicted that “it is reasonable to assume that more companies than in the past will exhibit one or more indicators of substantial doubt.”
However, the downturn — including the collapse of several industries, such as the housing markets and the auto sector — itself has put the long-term forecasting ability of auditors and companies into question. After all, says Nussbaum, “the vast majority of people including economists did not see this coming, and certainly auditors didn’t see it happening.”
Look for More Faulty Forecasts
Nussbaum expects there will be some more faulty forecasts in the year to come. “The high level of volatility resulting from the downturn in the economy makes it almost impossible for the auditor or even the company to predict successfully what will happen 12 months from now.”
The new FASB rule tells management to look ahead at least 12 months when assessing their company’s viability. But the current auditing standards tell the firms to keep their assessments to under a year from when they review a company’s financial statements. The discrepancy didn’t sit well with critics of FASB’s proposal, including the audit firms. “To expect management to make judgments about conditions and events that may exist or occur 18 or 24 months from now, or even later, may be unrealistic and impracticable,” Deloitte wrote.
The standard-setters will revisit whether the auditing standards need to change because of the time-horizon difference. “If the FASB establishes a time frame that is different than what auditors currently are required to consider, it is important that we take another look at the auditor’s responsibility,” says Ray. He added that, while it might not be necessary for an auditor to evaluate the same time period management is required to assess, the PCAOB likely will consider how well investors will understand any such difference.
For now, FASB plans to stick to the 12-months-plus guideline, which doesn’t please finance executives who will have to expand their outlook. “For any exercise where you look past one year, it’s an assumption based on whether you have a glass half-full or half-empty perspective,” says Don Elsey, CFO of Emergent BioSolutions, a biopharmaceutical company based in Maryland.
Additional reporting by Stephen Taub.