Going concern guidance for audit engagements
The topic of going concern is especially relevant today, given the many uncertainties resulting from the current health and economic crises. Companies of all sizes in all industries are faced with closures of specific locations or complete shutdowns, employee layoffs and restrictions on work, liquidity issues, and disruptions to their supply chains and customers. Revenues are being negatively impacted as a result. While some entities (such as those related to health care) may not be negatively impacted by the COVID-19 global pandemic, entities in many different industries and locations have experienced negative impacts that need to be evaluated. As a result, auditors and financial statement preparers need to brush up on the existing going concern requirements to address those situations.
Generally Accepted Accounting Principles
For all types of for-profit and nonprofit entities, FASB ASC 205-40, Presentation of Financial Statements-Going Concern, includes the required accounting and disclosure requirements. Under this ASC, continuation of an entity as a going concern is presumed as the basis for reporting unless liquidation becomes imminent. Even if liquidation is not imminent, conditions and events may exist that in the aggregate raise substantial doubt about the entity's ability to continue as a going concern, which is defined as the probability that the entity will not be able to meet its obligations as they become due within one year after the date the financial statements are issued or available to be issued (often referred to as the one year look-forward period).
FASB ASC 205 requires that management evaluate this probability when preparing GAAP-basis financial statements each annual and interim period. The evaluation is based on qualitative and quantitative information about relevant conditions and events that are known or reasonably knowable at the time the evaluation is made, such as a reduction in sales due to store closures, shortage of products and supplies use in manufacturing operations, limitations in employee resources, decline in value of assets held by the company, the funds needed to maintain operations and meet obligations within a year of the financial statements, and liquidity and access to credit. If this evaluation results in management concluding that there is substantial doubt about the entity's ability to continue as a going concern, management must evaluate whether it has mitigation plans that can be effectively implemented within the one year look-forward period that are probable of alleviating substantial doubt when they are implemented. The FASB's use of the term probable in FASB ASC 205 means likely to occur and is consistent with its use with respect to contingencies in FASB ASC 450.
There are specific disclosure requirements whether substantial doubt is alleviated or not. In either case, the required disclosures include the principal conditions or events that raised substantial doubt, and management's evaluation of the significance of the conditions to the entity's ability to meet its obligations. If substantial doubt is alleviated by management's plans, those plans must be disclosed. If it is not alleviated, management's plans intended to mitigate the substantial doubt shall be disclosed. In that situation, the notes to the financial statements should also include a statement indicating that there is substantial doubt about the entity's ability to continue as a going concern.
AU-C 570B, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, discusses auditor responsibilities relating to going concern. These include obtaining sufficient audit evidence and concluding on the appropriateness of the entity's use of the going concern basis, determining whether substantial doubt exists about the entity's ability to continue as a going concern, understanding and assessing management's plans for addressing any conditions or events that raise substantial doubt about the entity's ability to continue as a going concern (if applicable), evaluating financial statement effects and disclosures, and reporting appropriately. AU-C 570B includes procedures auditors should perform throughout the audit and for the period beyond management's evaluation. It also includes potential indicators that may raise substantial doubt, along with potential mitigation plans management may implement.
The most difficult aspect for auditors related to the COVID pandemic will likely be the evaluation of management's plans. For many entities, their plans are in a state of flux with the volatility of the current environment in which they operate, and their plans may be changing daily. Similarly, updated cash flow projections to support management's plans may not be available or may be less reliable because of major uncertainties due to the COVID pandemic. However, the evaluation of management's plans will be necessary in determining whether the Company's disclosures are adequate and the likelihood of needing to add a going concern emphasis-of-matter paragraph to the report.
AU-C 570B applies to audits of financial statements prepared in accordance with special purpose frameworks even if the going concern basis of accounting is not relevant or the framework does not specifically require management to evaluate the entity's ability to continue as a going concern. It requires a conclusion based on audit evidence about whether substantial doubt exists, and an evaluation of the potential financial statement effects and the adequacy of going concern disclosures.
AU-C 570B includes guidance and examples about the form of audit report to be issued if conditions or events that raise substantial doubt about the entity's ability to continue as a going concern have been identified. If the auditor concludes that substantial doubt about the entity's ability to continue as a going concern exists, and management's plans do not alleviate the substantial doubt, the audit report should include an emphasis-of-matter paragraph.
Following is an example of an emphasis-of-matter paragraph when substantial doubt exists about the entity's ability to continue as a going concern due to the COVID-19 global pandemic and management's plans do not alleviate the substantial doubt:
Substantial Doubt about the Company's Ability to Continue as a Going Concern
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note X to the financial statements, the Company has been required by governmental authorities to close a number of its locations as a result of the COVID-19 pandemic, and its suppliers and customers have also been impacted by those governmental restrictions. The closures have caused a material adverse effect on the Company's revenues, results of operations, and cash flows, including the Company's ability to meet its obligations when due. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's evaluation of the events and conditions and management's plans regarding those matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to that matter.
AU-C 570B.25 explicitly states that the emphasis-of-matter paragraph should not use conditional language. Accordingly, language such as the following would not be appropriate to use in the emphasis-of-matter going concern paragraph:
If the Company continues to suffer recurring losses from operations as a result of the COVID-19 pandemic, there may be substantial doubt about its ability to continue as a going concern. [Emphasis added.]
If conditions or events that raise substantial doubt about the Company's ability to continue as a going concern are identified but are alleviated by management's plans (assuming financial statement disclosures are adequate and an unmodified opinion is appropriate), auditors may, but are not required to, include an emphasis-of-matter paragraph that refers to management's disclosures about the conditions or events and management's plans. Following is an example of an optional emphasis-of-matter paragraph that would be appropriate in that circumstance:
Emphasis of Matter
As discussed in Note X to the financial statements, the Company has suffered losses from operations as a result of the COVID-19 pandemic and has a net capital deficiency. Management's evaluation of the events and conditions resulting from the COVID-19 pandemic and management's plans to mitigate those matters are also described in Note X. Our opinion is not modified with respect to that matter.
Regardless of whether substantial doubt has been alleviated by management's plans, the auditor should evaluate the related financial statement disclosures. If going concern disclosures are not adequate, or if information has been omitted or is incomplete, either a qualified or adverse opinion may be appropriate under the guidance in AU-C 705B. An emphasis-of-matter paragraph in the auditor's report about the going concern uncertainty is not a substitute for including the required disclosures in the notes to the financial statements.
AU-C 570B.23 notes that if the financial statements have been prepared using the going concern basis of accounting but the auditor determines it is inappropriate (i.e., the financial statements should be prepared on the liquidation basis of accounting), the auditor should issue an adverse opinion on the financial statements.
PPC's Guide to Auditor's Reports provides extensive guidance and illustrative reports for many of the reporting problems that auditors encounter in their audit engagements, including situations where auditors are dealing with going concern uncertainties. Report examples include situations where the report is modified for a GAAP departure when going concern disclosures are not adequate and an example report with a disclaimer of opinion related to the going concern uncertainty. Other Thomson Reuters to aid your audit engagements include: PPC’s Guide to Audits of Nonpublic Companies, PPC’s Guide to Audits of Nonprofit Organizations, PPC’s Guide to Construction Contractors, PPC’s Guide to Preparing Financial Statements, and PPC’s Guide to Preparing Nonprofit Financial Statements.