Going Concern Disclosure: What It Is and When It’s Needed

Financial statements are prepared under the going concern assumption, a principle that presumes a business will continue its operations for at least one year from the date its financial statements are issued. This outlook allows for the orderly recognition of assets and liabilities, such as depreciating equipment over its useful life rather than valuing it at an immediate liquidation price. The entire structure of accrual accounting relies on this idea of operational continuity. Without it, financial statements would be prepared on a liquidation basis, which presents a much different financial picture.

Conditions That Raise Substantial Doubt

Under U.S. Generally Accepted Accounting Principles (GAAP), as detailed in ASC Topic 205-40, management must evaluate if conditions raise substantial doubt about the company’s ability to continue as a going concern. This evaluation is required for each annual and interim reporting period. Substantial doubt exists when it is probable a company will be unable to meet its obligations as they become due within one year after its financial statements are issued.

A primary category of concern involves negative financial trends. These can include recurring operating losses, working capital deficiencies where current liabilities exceed current assets, and persistent negative cash flows from operating activities. Adverse shifts in key financial ratios, such as a rising debt-to-equity ratio or declining current ratio, also fall into this category.

Internal matters within the organization can also signal operational risk. The loss of key management personnel, ongoing labor difficulties such as strikes, or a substantial dependence on the success of a single major project can disrupt operations and strategic direction.

Events external to the company can impact its viability. Legal proceedings or regulatory actions could result in financial penalties or operational restrictions that jeopardize the business. The loss of a key franchise, license, or patent, or the departure of a principal customer or supplier can also create a financial crisis.

Other indicators relate to a company’s debt and credit status. Defaulting on loan covenants or being unable to make scheduled debt payments are clear signs of financial instability. A company may also face a denial of trade credit from its suppliers or need to seek debt restructuring to avoid default.

Management’s Plans to Mitigate Doubt

When conditions raise substantial doubt, the analysis shifts to management’s plans to resolve the underlying issues. These plans can only be considered if it is probable they will be effectively implemented and will successfully mitigate the conditions causing the doubt.

One common strategy is a plan to dispose of assets. This could involve selling a segment of the business or other significant assets to generate immediate cash flow. For this plan to be considered viable, there must be a realistic market for the asset, and management must have the authority to execute the sale.

Another set of plans revolves around borrowing money or restructuring debt. Management might seek new lines of credit, attempt to refinance existing loans at more favorable terms, or negotiate with lenders to delay principal payments. The feasibility of these plans depends heavily on the company’s relationships with its lenders and its available collateral.

Companies may also develop plans to reduce or delay expenditures. This can include cost-cutting measures like reducing administrative overhead or postponing non-essential projects. Management must also consider their potential long-term negative effects, such as falling behind competitors or operational inefficiencies.

A fourth category of mitigation involves plans to increase ownership equity. This could be achieved by issuing new shares of stock or by securing additional capital contributions from existing owners. The success of such a plan is contingent on market appetite for the company’s stock or the owners’ willingness to inject more funds.

Crafting the Footnote Disclosure

When substantial doubt about a company’s ability to continue as a going concern exists, specific disclosures in the financial statement footnotes are required. If management’s plans are not sufficient to alleviate the substantial doubt, the footnote must explicitly state that there is substantial doubt about the entity’s ability to continue as a going concern for one year. The disclosure must also describe the principal conditions and events that gave rise to this doubt.

The disclosure must also detail management’s plans intended to mitigate these conditions. This provides a balanced view, showing that management is actively trying to resolve the issues, even if the plans are not deemed sufficient.

If management concludes that its plans do alleviate the substantial doubt, a disclosure is still required. In this scenario, the footnote will not state that substantial doubt exists, but it must still describe the initial conditions that raised the doubt and management’s plans that successfully mitigated it. This ensures users are aware of the challenges the company faced.

Impact on the Auditor’s Report

The presence of a going concern disclosure in a company’s financial statements has a direct effect on the independent auditor’s report. The auditor has a separate responsibility to highlight this issue for users of the report.

When an auditor concludes that substantial doubt remains, the audit report is modified. This modification takes the form of an explanatory paragraph added immediately after the opinion paragraph. This paragraph will have a title such as “Substantial Doubt About the Entity’s Ability to Continue as a Going Concern” and will refer the reader to the detailed footnote disclosure prepared by management.

This explanatory paragraph is not a qualification of the audit opinion. The auditor can still issue an unmodified, or “clean,” opinion on the financial statements, meaning they are presented fairly. The paragraph simply emphasizes a matter for the reader’s understanding.

A more severe consequence arises if the auditor finds the company’s footnote disclosure to be inadequate. If management fails to provide the necessary information or the disclosure is misleading, the auditor may issue a qualified or adverse opinion. A qualified opinion states that the financial statements are fairly presented except for the inadequate disclosure, while an adverse opinion states that the financial statements are not fairly presented.