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New going concern auditing standard proposed…so what?

Last week the AICPA’s Auditing Standards Board (ASB) released its exposure draft entitled “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.”  This proposed standard is designed to supersede SAS No. 126 (AU-C 570).  So, what should we learn from it?

To begin, the ASB made it clear that it wants to achieve three main goals with the exposure draft.  First, the ASB wishes to provide interpretative guidance on key aspects of the going concern assumption.  This interpretative guidance is, in part, designed to incorporate into the auditing standards the FASB’s ASU No. 2014-15 on going concern issued in 2014.  Second, the ASB wishes to converge the U.S. GAAS auditing standard on going concern (currently SAS No. 126) with International Standard on Auditing (ISA) No. 570 (revised).  And third, the ASB has designed this exposure draft to apply to different financial accounting standards, thereby necessitating a going concern standard written in a neutral accounting framework manner.

While the implications of this exposure draft may be varied depending on the circumstances in which it may be applied, I wish to focus today’s post on one aspect of this exposure draft–that of the definition of “substantial doubt.”

Substantial doubt

Paragraph A4 to this exposure draft reads:

A4. The FASB standards define substantial doubt about an entity’s ability to continue as a going concern as follows:

Substantial doubt about an entity’s ability to continue as a going concern exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable). The term probable is used consistently with its use in topic 450 on contingencies.

Other applicable financial reporting frameworks may use different terms that are similar to substantial doubt. For example, International Financial Reporting Standards (IFRS) use the terms material uncertainty and significant doubt. Also, other applicable financial reporting frameworks may not use probable as their threshold. For example, IFRS uses “may cast significant doubt on the entity’s ability to continue as a going concern.” This SAS uses the terminology of the FASB standards and GASB statements; if an audit is performed under another financial reporting framework, the requirements and application guidance may need to be adapted as necessary. (emphasis added)

Clarification

Since the issuance of ASU No. 2014-15 there has been a disconnect in terms of the above definition of “substantial doubt” between U.S. accounting standards and U.S. auditing standards, which I discussed in a previous post.  In fact, this disconnect became a hot topic in one of my former consulting engagements of a Fortune 1000 company.  However, with the expectation that this definition will find its way in a new auditing standard on going concern, we should see agreement between these two sets of standards.  If adopted, the exposure draft will be effective for audits of financial statements for periods ending on or after December 15, 2017.

I find this a big step in the right direction to clarify auditing standards on this point.  Should practitioners take interest in this topic and wish to provide feedback to the ASB, comments are due on September 5, 2016.

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What others have said in the past and why it matters

In the past I’ve worked on a number of financial disputes dealing with improper accounting for liabilities, among other things.   In one such instance, the plaintiff alleged that the defendant understated certain liabilities and, as a result, the defendant’s historical financial statements were materially misstated.

To support his opinion, the plaintiff’s expert relied on certain documents produced in the litigation that my team believed were taken out of context.  What was somewhat comical about the situation was that the alleged understatement was so large that it left a number of us scratching our heads.  We wondered why would anyone have gone into that particular business at the time if they “knew” (using the plaintiff expert’s words) they had to record certain liabilities as large as what the plaintiff’s expert claimed.  Indeed, no company in the industry at the time was recording liabilities anywhere near the extent that the plaintiff’s expert alleged should have been recorded by the defendant.

As experienced forensic accounting practitioners and expert witnesses understand, hindsight provides a clear picture of what took place and whether or not it was reasonable.  On the other hand, hindsight can be difficult to justify its reliance.  In particular, if the facts and circumstances known to an entity at the time were the best available information, then they may be considered reliable and reasonable.

Contemporaneous understanding

This brings me to my topic for today, that of understanding what others were saying and doing at the time.  More specifically, to follow my story through I will discuss the importance of identifying (generally speaking, without disclosing confidential information) what the plaintiff in this case was saying at the time and why it matters in a dispute.

For privately-held businesses, obtaining contemporaneous information may prove to be a challenge.  This is because private companies tend to disclose less (or sometimes no) information to the public.  In contrast, publicly-traded companies are held to a higher standard of public disclosure through various means.  These public disclosures can prove to be a treasure chest of information.

Back to my story of the plaintiff, which happened to be a publicly-traded company and a user of the defendant’s financial statements.  The plaintiff’s expert claimed there were all sorts of red flags at the time that the defendant prepared its financial statements.  Further, the plaintiff’s expert alleged that the defendant “should have” noticed these red flags and incorporated them into its accounting decisions.

What I find intriguing is that during the time period in dispute the plaintiff publicly disclosed that it believed the market factors affecting these accounting liabilities were not of big concern.  This was important because the plaintiff’s public statements lent credence to the liability accounting decisions made by the defendant.  Were we able to find these public statements by the plaintiff in the plaintiff’s complaint?  Of course not.

When an entity is in the public light, it provides information to the public in multiple ways.  So, knowing where to look for these types of public statements made our job easier.

SEC resources

A fabulous resource for identifying public statements is the SEC’s website.  For those less familiar, the SEC’s website archives various public filings.  In my experience, the following resources are helpful in identifying historical public statements:

  • Form 10-K – This is probably the most commonly known SEC form.  SEC registrants are required to file this annual report with the SEC, including annual financial statements, related schedules and various textual information.  SEC registrants also include discussion and analysis of financial trends within a section called Management Discussion and Analysis (MD&A).
  • Form 10-Q – SEC registrants are required to file this quarterly report with the SEC, consisting primarily of the company’s quarterly financial statements.  These forms also include a section on MD&A.
  • Form 8-K – These SEC forms can contain a wealth of information.  SEC registrants are required to file these forms with the SEC when certain significant, reportable events occur.  Examples include: quarterly press releases, major acquisitions, material contracts, and legal proceedings.
  • Comment Letters – Generally, the SEC publishes comment letters that it sends to SEC registrants, which can be identified by filtering for “UPLOAD.”  Similarly, the SEC publishes letters it receives from registrants on the SEC’s website, which can be identified by filtering for “CORRESP.”  Because the SEC is a regulator with a heavy hand, what a company writes to the SEC matters greatly.  Therefore, practitioners should pay specific attention to letters between the SEC and registrants.

Other resources

I have found the following other resources to also be worthy of digging through in search of relevant information:

  • Company website – Companies issue press releases and post them on their website.  Practitioners should be aware that not all company press releases are filed with the SEC via Form 8-K.
  • Industry news and reports – Depending on in which industry a company operates, there may be industry publications from reputable sources.  Again, these sources can provide reliable information that was known or communicated at the time.
  • General media communications – Media outlets may overlook or de-emphasize some aspects of company press releases.  In order to attempt to have a degree of control of the narrative, companies often have relationships with major media outlets.  Running web searches of public statements made by company personnel can generate interesting results.

Relevance

As one can gather from my story, it certainly doesn’t help the plaintiff’s case when it was disclosing to the public a certain narrative at the time, but then it switched gears and makes contradictory allegations later in support of its lawsuit.  Therefore, when looking to the correct sources, experienced forensic accountants can find valuable information.  This information can help to obtain a more full, or correct, understanding of the facts and circumstances at the time to assist their clients in all types of dispute matters.

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How to effectively identify a peer group

When writing expert reports I am often faced with the task of carefully benchmarking an entity against its peers. Disputes often deal with alleged accounting failures of an entity to recognize, disclose, or perform some other activity appropriately. Alternatively, financial statement preparers, users of financial statements, and/or auditors may wish to assess the reasonableness of management’s accounting recognition and disclosures against other entities.  For these reasons it is imperative that a careful benchmarking exercise be performed to assess the reasonableness of an entity’s accounting decisions in light of the decisions of peer entities. In this post I define peer entities as those entities that are most closely related to or aligned with the subject entity.

On the surface it may seem relatively straightforward to identify a peer group. However, when one peels back the onion the nuances begin to surface and, if not careful, practitioners may find themselves in a tough situation trying to defend their thought process in a rebuttal report, deposition or trial or trying to explain variances that prove to be irrelevant.  Today’s post will discuss some helpful tips to consider when selecting an appropriate peer group for benchmarking purposes.

To begin, a practitioner should have sufficient knowledge and understanding of the entity’s business and the industry in which it operates. Following are some items to consider to test ones knowledge and understanding of an entity’s business environment, not in any particular order:

  • What types of products or services does the entity offer?
  • Are any of these products or services different from other entities within its industry?
  • Does the entity operate in a regulated industry?
  • Is the entity publicly traded, or are the entity’s financial statements publicly available?
  • If so, what potential peer entities has the entity disclosed within its annual report (i.e., SEC Form 10-K) (more on this below)?
  • Can one easily identify the Standard Industrial Classification (“SIC”) code of the entity (more on this below)? Or, can one identify at least one potential peer entity that is similar to the entity, whose SIC code is readily available?
  • Do industry publications exist from a reputable source that may identify potential peer entities?

Screening considerations

Upon responding to the questions above, one focuses on a list of potential peer entities; however, it may still be necessary to screen the list further. I generally screen entities based on key financial metrics, which may include: assets, revenues, equity, net asset value, PP&E, headcount, or some other specific account or disclosure in the financial statements (depending on the nature of the research or litigation one is addressing).

Alternatively, one may look to segment disclosures in the financial statements, which often include disaggregated financial metrics based on geography, product line, or some other meaningful attribute. Furthermore, market capitalization may be meaningful; however, one should take caution with relying on this metric as it may be more volatile relative to other financial metrics.

In some cases, an entity may operate in a highly specialized industry. When this occurs and financial information of a direct competitor is not publicly available, one may consider selecting potential peer entities associated with the direct competitor that are upstream or downstream. In my view this is reasonable because upstream or downstream entities tend to have similar operations or business risks within the highly specialized industry.

Once a screening process is selected, one may also consider screening the same criteria for multiple periods to confirm that the selected screening criteria yield consistent results and, therefore, are reliable for benchmarking.

Annual Report Disclosures

SEC Regulation S-K Item 201(e) requires an SEC registrant to disclose a performance graph in its annual report (i.e., SEC Form 10-K filing).  This performance graph is relevant in the context of benchmarking because, depending on its business, an SEC registrant is required to construct a “peer group index,” which may identify potential peer entities of interest. The SEC guidance stipulates, “If the registrant uses a peer issuer(s) comparison or comparison with issuer(s) with similar market capitalizations, the identity of those issuers must be disclosed and the returns of each component issuer of the group must be weighted according to the respective issuer’s stock market capitalization at the beginning of each period for which a return is indicated.”

Care should be taken when relying on the SEC registrant’s selected peer group as the SEC guidance states, “If the registrant does not select its peer issuer(s) on an industry or line-of-business basis, the registrant shall disclose the basis for its selection.”  In the end, the judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented.

SIC Codes

The U.S. Bureau of Labor Statistics developed SIC codes to indicate an entity’s type of business.  SIC codes are categorized by major industry and sub-industry.  Public entities that file statements with the SEC include their SIC codes within their filings, which can be used for comparative analysis.

Application

The manner of execution of the benchmarking exercise can strengthen one’s position in a dispute.  Conversely, if left to inexperienced practitioners or lack of careful consideration, this exercise can create more problems than it was designed to solve. I’ve worked on a number of disputes wherein a robust benchmarking exercise was applied. In my experience well thought out benchmarking exercises have consistently played a critical role in persuasion of the arguments and opinions presented in the dispute.

In one such case a key allegation brought by an opposing expert dealt with inadequate accounting and disclosure of a particular FASB interpretation (“FIN”). My team carefully selected a peer group for comparison and we successfully demonstrated that diversity in practice existed with respect to peer entities complying with the disclosure requirements, which findings supported my client’s position.

In closing, I wish to reiterate that judgments or assumptions applied by a practitioner in connection with a benchmarking exercise must be adequately considered and documented for a successful outcome to occur.

Photo credit – Craig Jewell Photography