- Today’s challenging operating environment brings increased scrutiny from auditors and regulators, requiring companies to closely access their ability to continue operating as a “going concern.” Several macro challenges face management teams, including the impact of high inflation rates, broader market confidence, increased interest costs on variable debt and difficulties in effectively refinancing debt.
- Accounting Standards Codification (“ASC”) 205-40 details assessment requirements as well as required disclosures for the two-step process for determining probability of meeting obligations.
Companies should be prepared for increased scrutiny from auditors and regulators. A challenging operating environment requires management to sharpen its focus on assessing the ability of a company to continue operating as a going concern for at least a year after it reports its financial results.
As companies plan their year-end financial reporting, they must consider the company’s ability to continue as a “going concern.” Economic uncertainty along with rising interest rates and tightening in credit markets is continuing to stress many companies’ ability to provide assurance they’ll still be around in 12 months. Financial leadership in many companies will face new challenges as they must sharpen their focus on forecasting and cash flow modeling to provide disclosures that may not have previously been necessary.
A Challenging Operating Environment
Data reported by the U.S. Bankruptcy Court indicates that corporate bankruptcies have spiked significantly in the past year. Additionally, large credit rating agencies have published research suggesting rising high-yield loan defaults will not peak until sometime in the second half of 2024 – levels not seen since 2019 during COVID-19 lockdowns and 2009 during the financial crisis. In assessing a company’s ability to continue as a going concern, management will need to consider several challenges in the current environment, including:
- The impact of 50-year high in inflation rates on companies’ cost structures, margins and ultimately cash flows.
- Broader market confidence with the risk of possible recession and its impact on demand for goods and services.
- Increased interest costs on variable rate debt. The Secured Overnight Funding Rate (“SOFR”), a key benchmark interest rate for variable rate borrowings, has increased from near zero in early 2022 to over 5.3 percent currently.
- Ability to cost effectively refinance maturing debt. Higher interest rates, noted above, and tighter lending standards are making it difficult for companies to cost effectively refinance maturing, particularly fixed rate, debt.
Going Concern Consideration Through a Financial Reporting Lens
Accounting standards have required a management assessment about a company’s ability to continue as a going concern since 2017. Accounting Standards Codification (“ASC”) subtopic 205-40 sets out the requirements for managements’ assessment, as well as the required disclosures that must be made based on that assessment. In the first step of a two-step process, management must determine if it is probable that the company will be able to meet its obligations during the assessment period, which runs one year from the date the company’s financial statements are issued or available to be issued.
No disclosures are required, and the process is done if management determines that it is probable it can meet its obligations in the first step. Management proceeds to the second step in the process if substantial doubt exists. In this step, management considers its plans to mitigate the conditions and events underlying the substantial doubt. This is done to determine if it is probable those plans can be implemented during the assessment period and, when implemented, if it is probable they will alleviate the substantial doubt. Significant disclosures are required about the conditions that led to the determination of substantial doubt and managements’ plans regardless of the outcome of the second step.
Heightened Scrutiny of Going Concern Assessments
A company’s auditor will be taking a very hard look at management’s going concern assessment when there is even a hint of risk. Additionally, the financial statement disclosures made when there is substantial doubt are sure to draw close examination from investors, creditors, and regulators for public companies.
To ensure a smooth audit process and that financial statement disclosures ultimately meet the needs of investors, companies need:
- A comprehensive assessment of current conditions
- Robust projections and cash flow forecasts
- A well thought out and fully vetted management plan
Leveraging specialized expertise can be indispensable to already stretched management teams having to consider going concern issues for the first time. WilliamsMarston’s experience and proficiency in building cash flow projection models, preparing audit-ready documentation and drafting clear financial statement disclosures can help to significantly alleviate stress on management and ensure a smooth and successful reporting process.