Living with a Scarlet Audit Letter

Given a going-concern qualification, companies struggle to defy their auditors' prediction that they won't survive the year.

By the time an audit firm announces that it doubts one of its clients will be able to continue as a going concern for the next 12 months, the company in question is usually in the midst of a public downward spiral. It likely has liquidity problems, financing issues, and a plummeting stock price.

Clearly, it is an auditor’s duty to share doubts about a client’s viability with the market via a qualified audit opinion. But ”going concern” opinions from auditors usually make the company’s situation even worse. “It is very much a near death sentence for companies,” says Al King, former managing director of the Institute of Management Accountants and vice chairman at valuation firm Marshall and Stevens.

Such a qualification can result in tougher-to-get and more expensive financing deals, just when the company is most in need of a break. Indeed, once hit with a going-concern qualification, companies may succumb to a “self-fulfilling prophecy,” say accounting observers. The pariah status such an opinion confers all but forces investors, suppliers, and lenders to turn away, often driving a company on the brink of bankruptcy into a Chapter 11 filing.

As companies today struggle with ruptured covenants, leery banks, and a reeling economy, King laments that the “binary” rules — either “you’re OK or you will fail” — guiding accounting firms don’t allow auditors a wider range of possible warnings. Typically, an auditor’s opinion letter expresses “substantial doubt” about a company’s ability to last as a going concern over the next 12 months — a brand of fear and doubt it must bear for a full year from the day its annual report is issued.

Many companies are in this situation today. Last year, 21% of companies registered with the Securities and Exchange Commission had their going-concern status questioned — the highest proportion of companies this decade, according to research firm Audit Analytics. Moreover, the number of businesses filing for Chapter 11 increased 113% in the first half of this year, compared to the same period in 2008.

Experts predict a similar percentage of going-concern opinions will be filed for 2009 10-Ks. “Companies that got a going-concern opinion last year — if they’re still around — probably have not worked their way out [of their current condition],” says Rick Ueltschy, managing executive of accounting firm Crowe Horwath’s audit and financial advisory group. ”And we’ll see more companies that have continued to have financial conditions deteriorate over the year added to the list,” he says 

Indeed, the prospect has finance executives biting their nails. Nearly one quarter of 846 CFOs and controllers surveyed by Grant Thornton said they were more worried about the ability of their companies to continue as a going concern than they were a year ago.

To be sure, a going-concern qualification doesn’t always mean the end — through bankruptcy court or liquidation — is imminent. But it does portend a yearlong battle for the CFOs at the finance helm of these companies. They are tasked with reassuring creditors and business partners that, with the forebearance of their counterparties, they will survive and eventually prosper.

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