A new accounting standard in the United States that makes CEOs and CFOs responsible for disclosing when there is substantial doubt about a company's ability to operate as a going concern places a significant new burden on the executives, experts say.
The new standard, issued by the US Financial Accounting Standards Board in August, for first time places the responsibility on management to disclose such doubt in the footnotes of their financial statements.
The companies will have to disclose that substantial doubt exists, even though that doubt has been alleviated by a mitigation plan, when the executives deem it probable that the company will be unable to meet its obligations as they become due within a year of the statements' issuance.
The standard goes into effect with fiscal years ending after December 15, 2016. The International Accounting Standards Board has decided not to proceed with a similar amendment.
Quantitative and qualitative judgements
In a paper that has been submitted for publication to the Association for Financial Professionals, two corporate financial consultants note that US companies previously made such disclosures inconsistently and that it was up to its auditor to decide when they should be made. And as the authors, Jeff Wallace and Jim Simpson, principals in Debt Compliance Services, put it, the auditor "was understandably conflicted about when to pull the trigger."
Under the new standard, Wallace and Simpson note that management will have to justify its ability to operate as a going concern, while auditors will then be able to evaluate that justification in the same manner they do other management assertions.
The paper explains that the standard requires management to use a number of quantitative and qualitative judgments about a company's financial condition, including:
- available liquid funds and access to credit
- conditional and unconditional obligations due within one year of the issuance date, regardless of whether those obligations are recognized in its financial statements
- funds necessary to maintain the company's operations considering its current financial condition, obligations and other expected cash flows within that period
- "other conditions and events" that may adversely affect the company's ability to meet its obligations during that interval
Examples of such conditions and events include everything from debt defaults, denial of trade credit, and the need to restructure debt to avoid default, dispose of assets, or seek new sources or methods of financing as well as internal matters such as work stoppages or other labor difficulties and external matters such as legal or regulatory matters that might jeopardize a company's ability to operate, the loss of a key franchise, license or patent, principal customer of key supplier; or an inadequately insured catastrophe.
To satisfy the standard, say Wallace and Simpson, management must deem it probable that its mitigation plans will be implemented within the one-year interval and will mitigate the aforementioned events and conditions. And the plan must be approved before the statements are issued.
The consultants warn that companies will need to review the impact of such a disclosure on their debt covenants. "The GAAP determination that substantial doubt exists and is not being alleviated will not come as a surprise to the senior lenders," the authors write. "By that time, these lenders will be actively engaging management on its actions, plans and forecasts to avoid bankruptcy."