The COVID-19 pandemic has resulted in one of the most rapid changes to the current economic environment the world has ever experienced. Restrictions on travel abroad as well as stay-at-home orders from a significant number of states and local jurisdictions within the United States have been implemented to reduce the spread of the virus. These restrictions are also affecting the business operations of entities throughout the country. The significant volatility in the stock market provides a frequent visual depiction of the rapidly changing future expectations for public companies as well as their privately owned peers.
Both the accounting and auditing standards require an evaluation of an entity’s ability to continue as a going concern prior to the financial statements or audit report being issued or made available to be issued (the financial statement issuance date). The requirement to evaluate an entity’s ability to continue as a going concern applies to both annual financial statements (e.g. Dec. 31, 2019 financial statements not yet issued, as well as quarterly statements, such as March 31, 2020 financial statements). This requires an organization to consider the most recently available information on its operations even if these facts and circumstances did not exist as of the end of the reporting period. Potential changes may be required to both the audit opinion as well as the organization’s disclosures when substantial doubt about an entity’s ability to continue as a going concern are raised, or exist, for a period of one year from the date the financial statements are issued or available for issuance.
The material uncertainties created by the pandemic and recent events may cast doubt about an organization’s ability to continue operating as a going concern and will need to be considered for accounting purposes prior to issuing financial statements. However, given the time and speed of changes, entities will likely struggle to understand and evaluate the potential impacts on their financial reporting. The following provides some key questions financial statement preparers should consider over the next few weeks as they prepare to issue financial statements.
What Does Our Current Business Environment Look Like?
In order to prepare an analysis of the ability to continue as a going concern, an entity needs to understand its operating environment at the date the financial statements are issued. This will require entities to evaluate and document their consideration of how the pandemic affects their activities.
The pandemic affects industries very differently. In some cases, an organization may have continued to operate and may have even seen an increase in customer demand, which is the case with Amazon, Wal-Mart, food delivery services, and agricultural products. Surges in demand, however, have come with their own potentially financially damaging consequences, namely supply and personnel shortages. The travel bans and stay-at-home orders have led to supply chain disruptions worldwide. Employees may have contracted the COVID-19 virus or be caring for loved ones who are ill or children who are home due to the pandemic-related school closings. Alternatively, some businesses have been required to close or significantly reduce their operations due to public health orders, such as movie theaters, entertainment venues, and restaurants. The impact of the COVID-19 virus is not expected to be consistent across all businesses and industries. Obtaining an understanding of the current business environment at the time of issuance of the financial statements will be an important step.
How Do I Account for Doubt?
ASC Topic 205-40 requires financial statement preparers to evaluate whether conditions or events raise substantial doubt that the entity will be able to continue as a going concern. While every entity’s situation will be different, broadly speaking, COVID-19 may affect this assessment in one of four main ways.
Substantial doubt exists prior to considering COVID-19
In this situation, if an organization is already experiencing negative cash flows or other major liquidity issues that have already created substantial doubt, the COVID-19 pandemic may simply be an additional negative risk to consider. However, the conclusion that substantial doubt exists would not be expected to change.
Conditions and events do not raise substantial doubt prior to considering COVID-19, and COVID-19 is not expected to have a significant negative impact on operations.
This may be the case for an organization that is viewed as an essential business or may have experienced only a minor reduction in customer demand or minor operational issues. An organization that operates a chain of grocery stores, for example, may be experiencing increased demand, although it may also be incurring additional cleaning expenses and reduced store hours. In this situation, the organization may be seeking additional employees and may even have record levels of growth. If this is the case, based upon the organization’s facts and circumstances, a conclusion that conditions and events do not raise substantial doubt may be appropriate.
Conditions and events do not raise substantial doubt prior to considering COVID-19, and COVID-19 is causing a significant negative impact on operations and liquidity.
If an entity has closed its operations — either voluntarily due to reductions in customer demand, or because a government required it to — the lack of current operations may by itself raise substantial doubt. In these situations, the organization should evaluate its existing liquidity and the expected impacts from the current economic situation. The entity may currently expect it will fail debt covenants or other contractual covenants for the first quarter of 2020 and may not be able to obtain a waiver from their lender. On the other hand, the organization may expect it will have insufficient liquidity without additional external financing. In these situations, an entity will likely conclude substantial doubt has been raised, despite the fact that it would not have had going concern issues absent the COVID-19 pandemic.
Conditions and events do not raise substantial doubt prior to considering COVID-19, and COVID-19 is causing an unknown negative impact on operations and liquidity.
The most challenging evaluation of whether conditions and events raise substantial doubt will likely be experienced for organizations that have not yet been able to determine the extent of the coronavirus impact on their operations. An entity may not have been required to close operations or may be operating via a remote workforce, but the impact on customers or vendors may not yet be known.
That is not to say that organizations that cannot measure the full effects of the pandemic response can safely adopt a “wait it out” approach. Organizations that anticipate even a small decline in operational performance may negatively affect their ability to meet debt covenants may be a condition that raises substantial doubt prior to the direct impacts of COVID-19 being known. Management may also be taking action currently to understand the pandemic’s impacts on the business and attempting to prepare for the most appropriate response. In such situations, entities should gather all relevant information including their current and short-term liquidity (i.e. when are debts due, do they have subjective acceleration clauses, and are they subject to covenants that could be violated) in assessing if substantial doubt has been raised. The absence of information should not be assumed to be a positive fact pattern given the current economic environment. Attempting to obtain whatever information is possible will be key to the conclusion about whether current conditions have raised substantial doubt about an entity’s ability to continue as a going concern.
Conditions and Events Have Raised Substantial Doubt About Our Ability to Continue as a Going Concern. What Comes Next?
If it is concluded that conditions and events raise substantial doubt about your organization’s ability to continue as a going concern, the next step is to gather the management team together. Are there already management plans in place that could alleviate the substantial doubt? This step is challenging as management’s plans first must be considered probable of being implemented, and then if implemented must be probable of being successful at mitigating the conditions which raised substantial doubt. For example, management’s plans to mitigate the going concern may involve re-opening their operations, but their operations were closed by a state or local government decision. This means management does not have the ability to implement their plans for an unknown amount of time. Alternatively, if management has the ability to implement their plans, but their existing liquidity is severely limited, their plans may be probable of being implemented, but not probable of alleviating the conditions and events that raised substantial doubt.
Management’s plans will be specific to the specific situation and the evaluation of their probability of success will be based on those individual details. Further, as the economic environment is continuing to change, management’s plans likely will as well. Financial teams should ensure they are using the most recent, relevant information in this evaluation because the evaluation must be updated through the date the financial statements are issued.
What Do We Disclose?
Accounting rules dictate that entities that determine they have conditions and events that raise substantial doubt about their ability to continue as a going concern must clearly state the facts and circumstances that led to that conclusion. This includes explaining to the users of the financial statements the conditions and events that raised substantial doubt and management’s evaluation of the significance of those conditions related to the ability to meet the entity’s obligations. The information disclosed should be specific to the operations and liquidity of the entity and avoid using boilerplate or generic language.
If your organization’s management’s plans are considered probable of being successful, you should also disclose information about the plans that alleviated the substantial doubt. On the other hand, many organizations may find that their management plans do not alleviate the substantial doubt about the organization’s ability to continue as a going concern. Such as, they may have significant uncertainty about the extent of a shutdown or reduction in operations that is beyond management’s control. When this occurs, disclosure should still be made of management’s plans that are intended to mitigate the conditions and events that raised substantial doubt, however, disclosure should also clearly state that substantial doubt about the entity’s ability to continue as a going concern exists. Entities in this circumstance will usually find their auditors will include an emphasis of matter paragraph in their report.
Being clear and transparent about the going concern analysis ensures that your organization’s financial statement readers have an appropriate understanding of current conditions.
Final Thoughts
Two of the most challenging components of the pandemic response are the speed at which new developments emerge and the uncertainty over how long travel disruptions and stay-at-home measures may need to last to mitigate the spread of coronavirus disease 2019. These developments can be negative, such as an extension of a stay-at-home order, or positive, such as the stimulus package. In this environment, organizations that have not been previously had substantial doubt about their ability to continue as a going concern may find themselves faced with this difficult conclusion and with too much uncertainty to mitigate the doubt through management plans.
Our team is here to help you navigate the accounting and related developments that arise from this pandemic. Contact us for more information or visit our resource center for up-to-date information on the other repercussions the COVID-19 virus may have on your organization.