Reporting a Going Concern 

Auditing

Reporting a Going Concern

Going Concern: The view that an organization will continue in operation in the foreseeable future and that its assets are therefore to be accounted for on the basis of continued use rather than on the basis of market or liquidation value. (Terminology for Accountants , CICA 4th Edition, 1992)

FROM: JUL-AUG 2004 ISSUE | BY ALISON ARNOT

All companies operate under the assumption that they’ll continue as going concerns, that they’ll survive over time. But sometimes their numbers tell a different story.

Stakeholders, meanwhile, need to know the exact state of a company’s financial affairs. With enough warning of possible business failure, potential investors can think twice about where to put their money, and existing shareholders can cut their losses. Lenders also need this information to assess the likelihood of default on a loan.

So do all businesses note going concern risks in their financial statements? The findings of a recent study indicate otherwise.

In Predicting Going Concern Risks in Canada (January 2004), University of Waterloo professors J. Efrim Boritz and Jerry Sun say that fewer than half (46 per cent) of the 249 companies studied that failed between 1987 and 2002 had textual disclosures about going concern risks. The term “failure” included firms that filed for bankruptcy, were placed in receivership, liquidated, underwent restructuring, or were involved in unusual actions such as cease trading orders or a delisting. Bankruptcy prediction models, on the other hand, correctly predicted failure in 75 to 90 per cent of the companies, depending on the model used. Not surprisingly, the shorter the interval between the financial statement date and the date of failure, the more accurate the going concern risk disclosures. But why such a discrepancy between the companies’ own predictions on their financial future and those done by the study’s bankruptcy prediction models?

"The general consensus is that going concern disclosures of many companies are inadequate,” Boritz says. “This inadequacy is likely the result of management’s lack of motivation to draw attention to going concern problems and the absence of standards requiring auditors to be more proactive in identifying and reporting going concern problems.”

What is the extent of management’s responsibilities regarding going concern risk disclosure? And what are an auditor’s obligations? Existing Canadian standards are not clear, which is a problem the Accounting Standards Board (AcSB) and the Auditing and Assurance Standards Board (AASB) are taking steps to remedy.

Bankruptcy Prediction

When discovering a potential going concern risk in his audit clients, Nova Scotia public practitioner David Etter, FCGA, will first go back to the client and ask that a note be included in the financials. To do this, he needs to have a measurable basis for his opinion and has found the bankruptcy prediction model Z-Score Analysis, developed in 1968 by New York University professor Edward Altman, to be an accurate measure.

Z-Score Analysis is one of several models used in the Boritz and Sun study. Others, which Boritz found to be even more effective, include three Canadian models — Springate (1978), Altman and Levallee (1980), and Legault and Veronneau (1986) — and another U.S. framework, Ohlson (1980).

If a company has a low z-score, Etter will ensure that there is a going concern risk disclosure. “I take it quite seriously,” he says. “I think it is the role of the auditor ... We have a responsibility to ensure that the entity is a going concern ... If I feel that the company is headed for bankruptcy, I have no choice but to disclose it. If they don’t disclose it in a note, I have to disclose it in my audit report.”

He points out, however, the danger in including this information in his own notes, since the auditor could expose himself or herself to liability. His, and likely most auditors’, preference is to have going concern risk disclosure included in the company’s financial statements. “If it’s disclosed in the statements, then the statements are presented fairly,” Etter points out, so there is no need for the auditor to mention it.

Bankruptcy prediction models can help auditors evaluate the going concern assumption by providing the necessary proof when they discuss problems with clients and recommend changes to the financial statements. They can also provide legal defence, if necessary.

However, two types of errors can occur when applying bankruptcy prediction models: a type-one error occurs when a model incorrectly classifies a failed company as non-failed; and a type-two error occurs when a model incorrectly classifies a non-failed company as failed. The implications of a type-one error, Boritz and Sun explain, are that management may not be aware of the seriousness of the situation, investors may not have enough warning of imminent failure, and auditors could damage their reputation or face litigation. Meanwhile, a type-two error could become a “self-fulfilling prophesy,” in which the model’s prediction actually causes a healthy company to fail. Also, to avoid type-two errors, auditors could incur high investigation costs.

“What the profession seems to feel in Canada is that type-two errors are more costly than type one,” says Stephen Spector, FCGA, teacher of financial and management accounting at Simon Fraser University in British Columbia. “If the auditor publicly says, ‘I have going concern concerns,’ what’s that going to do to the investors? If I say, ‘You’re in terrible shape,’ and the investors say, ‘They’re in terrible shape. I better get out,’ it creates a downward spiral.” Instead, an auditor should explain the problem to management and make sure they take steps to fix or disclose it, Spector says.

Standard Concerns

Canadian guidance on auditing and accounting for going concern falls short. “There are auditing standards without corresponding accounting standards,” Boritz says. “It’s very hard to audit something if management hasn’t already accounted for it ... You’re limited as to what you can do ... The going concern assumption is part of the accounting system, not part of the auditing system.”

Canadian accounting standards provide a definition of going concern and what it’s used for, but don’t provide specific guidance on what to do if there are risks, Boritz explains. In addition, Canadian standards differ from U.S. and international standards. CICA HandbookSection 5510 states that, if a company adequately discloses going concern risks in the notes to the financial statements, then the auditor is not permitted to mention these risks in the auditor’s report. This differs from the United States, where SAS 59 requires auditors to include in their reports a paragraph on their conclusions regarding going concern.

Spector explains that, when looking at the going concern issue in the late 1990s, the AcSB assessed the potential liability auditors could face in mentioning going concern risks and decided against any requirement. The thinking was that if a company fully discloses going concern issues in the notes, then the auditor has discharged his or her responsibility because the notes disclose the financial position of the enterprise. “The financial statements are deemed to be prepared fairly and in accordance with GAAP,” Spector says.

But this situation is likely to change. In response to various studies indicating that there is not enough warning of going concern problems, the AASB is currently developing specific assurance recommendations that will provide guidance on the auditor’s responsibility when considering a business’s ability to continue as a going concern. The recommendations will provide basic principles and guidelines on the auditor’s actions and reporting requirements and will align Canadian standards with U.S. and international standards (see below, “Creating a Canadian Standard”).

In conjunction with the AASB project, the AcSB is developing clearer guidance for management regarding its responsibilities when considering going concern. The AcSB is revising Section 1000,Financial Statement Concepts, based on the guidance found in IAS 1, Financial Statement Presentation. “The [AASB]’s concern was that they couldn’t write guidance on what an auditor should do in terms of auditing going concern without there being something more in the accounting handbook about what management should do first,” says Ian Hague, of the Accounting Standards Board. “All there is in the accounting handbook on guidance relative to going concern is one paragraph in Section 1000. Nothing says, when management is assessing whether to prepare financial statements on the going concern basis, what things they should take into account or how far out into the future they should look.”

An Ongoing Concern

Boritz and Sun’s findings mirror the results of other studies done in the United States and the United Kingdom, indicating that there may be a serious lack of disclosure of going concern risks.

Still, Etter finds the study results surprising, saying he would have expected the number of companies that failed without disclosing going concern risk to be more like 10 per cent. “There’s always going to be a point where it’s just beyond the company’s control,” he says, providing as examples economic dependence on another company, environmental disaster, or an unanticipated lawsuit.

“Relying on a note disclosure in one year’s financial statements is not an accurate predictor of failure,” Spector says, adding that it’s not surprising the bankruptcy prediction models produced more accurate results, since they are based on a time series or other form of analysis with more than one data point.

More can be done to predict risk before failure, Boritz says, namely greater use of bankruptcy prediction models. “It’s uncanny how quickly and easily they can distil the numerical information in financial statements into a thumb’s up or a thumb’s down signal.” The auditor can then go ask questions, as can the financial analyst, and private investors can be cautious about where to put their money.

The uncertainties and the legal minefield surrounding going concern disclosure may become easier to navigate. With the new guidelines being prepared by both the AASB and the AcSB, a company’s management and its auditors will have more guidance on roles and responsibilities when disclosing a firm’s ability to continue as a going concern.

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Alison Arnot is a freelance writer and editor based in Ottawa.