Estimated reading time: 7 minutes
Are you required to issue financial statements prepared under generally accepted accounting principles, or GAAP? Do you report on a calendar year basis? If so, it’s time to start thinking about financial reporting for year 2020. Over the next few weeks I’ll be talking about things to consider as you prepare your 2020 annual financial statements. High on the list is an evaluation of your company’s ability to continue as a going concern. Thinking about these things now will save time for you and your accountant. An important thing to note here is that obviously this article is general in nature. I am not offering specific advice to you or your company. You should always discuss these matters with your company’s accounting, financial and legal advisors.
GAAP
The authoritative source of Generally accepted accounting principles, or GAAP is the Financial Accounting Standards Board, or FASB Accounting Standards Codification. For more information visit their website. GAAP applies to all nongovernmental entities reporting in the U.S. In addition to GAAP requirements, publicly-traded companies may have additional reporting requirements under the rules of the U.S. Securities and Exchange Commission, or SEC.
Not all companies prepare GAAP financial statements. They are frequently required by lenders or investors and if you intend to “go public” someday, GAAP financial statements will be a requirement. Whether you prepare GAAP financial statements or not, it’s a good idea to evaluate your company’s financial health and prospects at least annually, particularly this year.
One final point about GAAP. I’m writing this article about annual reporting. Many privately owned companies only prepare full GAAP financials annually. The requirements below apply equally to interim financial statements, so if you prepare full GAAP financials on a quarterly basis, you should be looking at going-concern every quarter.
What is a Going Concern?
Simply, a company is a going concern if it can meet its financial obligations as they become due. Under the GAAP rules, a company is either a going concern or is facing imminent liquidation. Basically, imminent liquidation means either the company’s management has made the decision to liquidate the company, or an outside party can compel liquidation (an involuntary bankruptcy petition, for example). Accounting for and reporting on companies facing imminent liquidation is beyond the scope of this article.
Going Concern Evaluation
As you prepare financial statements under GAAP, you should evaluate whether there are conditions and events, considered in the aggregate, that raise “substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued…” In other words, given the conditions of the company, its competitive environment, overall market conditions and other factors is it likely that the company will continue to be able to meet its financial obligations for at least a year from the financial statement issue date? The outcome of this evaluation can trigger additional disclosure requirements in the footnotes to the financial statements.
Under the best of circumstances, this is a complex evaluation. Year 2020 has not generally been the best of circumstances! Every business faces risks and uncertainties and this year we add the COVID pandemic into the mix. You need to evaluate your company’s ability to remain viable through early 2022 as you prepare your 2020 financial statements.
Conditions and Events to Consider
Here are a few examples of the types of uncertainties to consider. This is by no means a complete list, just a few ideas to think about.
Some examples
- Have COVID-related lockdowns affected your business? Arguably, the lockdowns may be temporary, but what if they aren’t?
- Perhaps due to the lockdowns, has your business’s marketplace changed? If you are a chain of retail stores, for example, have your customers buying habits changed to on-line versus in-person shopping?
- If you are in the hospitality industry, consider whether business travel and entertainment will return, or has the availability of virtual meetings at least partially eliminated the need for travel?
- Has your business lost critical talent? How likely is it that replacements will be found and retained? What will the impact be on future business if critical vacancies remain unfilled for prolonged periods?
- Is your business reliant on a single or few customers or suppliers who may be having financial difficulties?
- Is your business reporting negative financial trends, defaults on loans, an upcoming debt repayment, legal proceedings, unfavorable legislation or regulatory actions.
Evaluation process
Your evaluation should include all expected revenues and costs and the effects of other known events or circumstances. Does your analysis concludes that there is substantial doubt about your company’s ability to continue as a going concern? If so, think about and document the steps you might take to mitigate that doubt. We will call those steps “management’s plans.” To the extent management’s plans can be fully implemented before the financial statements are issued, it is appropriate to take them into consideration even if they occur after the balance sheet date. For example, if a company receives $10 million in additional capital in late January, and plans to issue its financial statements in February, the additional capital should be considered in the going concern evaluation.
Required Disclosures
The conclusion of your evaluation will result in one of three outcomes:
- There is no substantial doubt about your company’s ability to continue as a going concern.
- Substantial doubt is raised, but it is alleviated by management’s plans.
- Substantial doubt is raised and is not alleviated by management’s plans
There is no substantial doubt about your company’s ability to continue as a going concern:
If your evaluation concludes there is no substantial doubt about your company’s ability to continue as a going concern, then you are finished and no disclosure is required. Be sure to save all of your documentation related to the evaluation. The exception to this rule is if your company has previously disclosed substantial doubt which is now resolved, you should discuss in a footnote how the conditions and events that contributed to that substantial doubt were resolved.
Substantial doubt is raised, but it is alleviated by management’s plans.
Discuss the following in a footnote to the financial statements:
- The principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans)
- Management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
- Management’s plans that alleviated the substantial doubt.
- You should only include plans that will probably be implemented. As a general rule, for this purpose a plan can be considered probable only if it has been approved by management or others with the appropriate authority before the financial statements are issued.
- Some examples of plans could include plans to dispose of an asset or a business, plans to borrow money or restructure debt, plans to delay or reduce expenditures and plans to raise additional equity capital.
Substantial doubt is raised and is not alleviated by management’s plans.
Discuss in a footnote to the financial statements:
- The principal conditions or events that raised substantial doubt about the company’s ability to continue as a going concern (before consideration of management’s plans)
- Management’s evaluation of the significance of those conditions or events in relation to the company’s ability to meet its obligation
- Management’s plans that are intended to mitigate the events or conditions that raise substantial doubt.
Conclusion
One point I’d like to stress: do this evaluation at least once a year, especially this year. Even if it is not required. Do it as soon as you can. It can be an eye-opening experience. If you see trouble down the road there are probably steps you can take now to mitigate or even prevent a liquidity crisis later.
So far, we’ve talked about what needs to be done and why it is important. In part II of this article, I’m going to share a framework that I’ve used over the years to do this evaluation. I’ll also give some practical advice how to approach and perform your evaluation.
You might find my recent article “9 ways to improve your company’s budgeting process” helpful in preparing your going-concern evaluation.
If I can be helpful in your evaluation process, please let me know. I’m always happy to answer questions.