December 15 rapidly approaches, and financial reporting executives know what that means: new disclosure rules coming into effect for fiscal years ending after that date. The most interesting one may be the new standard for companies to assess their ability to continue as a going concern.
The Financial Accounting Standards Board adopted that standard, Disclosure of Uncertainty About an Entity’s Ability to Continue as a Going Concern, in 2014 to bring more uniformity to what companies disclose. Now that the effective date is here, some compliance and risk officers could have a tricky challenge confronting them.
The challenge is this: that management must first determine whether “substantial doubt” exists about the company’s ability to meet its obligations for the next 12 months. If doubt does exist, then the company must also disclose (in the footnotes) what steps management is taking to address it, and whether those steps will alleviate the risk.
All that assessment and disclosure must happen every reporting period. Meanwhile, your audit firm will still perform its own assessment of your ability to continue as a going concern, too. The Public Company Accounting Oversight Board sent the firms a practice alert in 2014 telling them to pay more heed to this issue, and to prepare for the new management disclosures that will be coming soon.
For a solid majority of companies, this standard will never be a significant headache because you won’t have substantial doubt about your ability to meet obligations. If you have no doubt, the standard’s requirements are met and you’re done. That’s the good news.
The bad news is that this standard is driving at better assessment and disclosure of your liquidity risk—and when liquidity risk does arise, it tends to arise quickly, from directions you didn’t expect. Recall all the financial firms that flirted with liquidity disaster in the fall of 2008. Better yet, recall the non-financial firms that suddenly wondered whether they might face liquidity problems, because their banks had lurched into lending paralysis. How do you identify risks like that?
Finding Multiple Red Flags
Let’s start with what “substantial doubt” about the company’s ability to continue actually means. As FASB defines it in the new standard, substantial doubt arises when circumstances and conditions in the aggregate make it probable that the company won’t be able to meet its obligations as they come due in the next 12 months.
As a risk management enthusiast, language like this gets me excited. It means the chief risk or compliance officer has to consider multiple risks and circumstances, to see whether they align in some threatening way. For example, the three obvious financial warning signs are: (1) negative cash flow from operations; (2) falling revenue; and (3) declining cash on the balance sheet.
Still, none of those metrics are large red flags individually. Amazon.com lost money hand over fist in the 1990s even as its revenues kept growing. Pharmaceutical companies routinely lose money for years, relying on investments of cash until that blockbuster drug finally wins approval. But a company suffering all three financial warning signs at the same time can be in dire trouble.
To demonstrate that thesis, I visited Calcbench.com and searched for large or mid-sized companies ($200 million or more in annual revenue) that met all three criteria—losses from operations, and falling revenue, and dwindling supplies of cash—for both 2014 and 2015.
We found 27 companies fitting that profile. You can read Calcbench’s more detailed discussion of our work if you want. For our purposes, these are the 10 worst offenders ranked by losses in operations.
Search the news headlines for these poor souls, and you’ll find few good outcomes. ReachLocal agreed over the summer to be acquired by Gannett. Avid Technology lost 75 percent of its market value in last 18 months. Imation, a data storage and security company, went from $6 per share in early 2014 to a penny stock today.
Those three financial metrics clearly are good examples of the “rolling threats” to a company’s survival. You can see the risk coming; you know when the financials turn against you. When a sufficient number are going the wrong way at once, you know management has a problem to address.
That said, the new going concern standard has two other variables to contemplate: “non-standard” threats such as a swift, severe financial surprise; and how management’s plans might offset the substantial doubt that’s been raised.
More Assessment & Disclosure
Non-standard risks are those ticking time bombs of liability that can explode quickly. Unexpected litigation damages are one example, although companies generally are much better today at disclosing contingencies to cover potential costs. (Teva Pharmaceuticals just did this, setting aside $520 million for a potential settlement—which, at 2.5 percent of 2015 revenue, was never an existential threat to the company anyway.)
Accounting gimmickry where liabilities are hidden off the balance sheet is another potential threat (recall Lehman Brothers with its $50 billion in hidden liabilities in the summer of 2008). Thankfully FASB has worked hard to bring these off-balance sheet tricks to light. The impending new lease accounting standard is one example.
Where disclosure might get sticky—or rather, where conversations among risk, compliance, and senior executives might get sticky—is around what to say about management’s plans to address substantial doubt. Not only does the company need to disclose what the plans are; you need to disclose how the plans will be effective at alleviating the doubt.
I’ve been in plenty of meetings where senior management unveiled plans to correct a failing business, and doubts were rarely alleviated at the end. Good luck having those conversations, and figuring out how to phrase the disclosures for the footnotes.
The standard does have a few caveats on that point. First, the company must disclose whether it’s “probable” that the plans will be implemented within the same assessment period. Second, the disclosure should say whether it’s probable that the plans, once implemented, will actually remediate the substantial doubt in question.
Those plans could be anything from raising new capital, to cost-cutting, to selling off assets, and so forth. Disclosing the plan itself isn’t nearly as important as disclosing how you expect the plan to work, and to prevent the company from grinding to a sudden halt.
We won’t know how much of a compliance chore this new standard might become for several months at least. Regardless, it’s a great example of what modern enterprise risk managers must do: observe numerous, evolving risks; develop counter-measures; and explain how those counter-measures will work.