Proposed FASB Accounting Rule Update to 'Going Concern' Presumptions May Increase Bankruptcy Filings
The Business Advisor
November 26, 2013
Presently, under U.S. generally accepted accounting principles (“GAAP”), financial statements are prepared under the inherent presumption that the reporting entity will be able to continue as a going concern; that is, the entity will continue to operate such that it will be able to realize its assets and meet its obligations in the ordinary course of business.1 The going concern presumption is critical to financial reporting because it establishes the fundamental basis for measuring and classifying assets and liabilities. Financial statements must be prepared under the going concern presumption unless and until an entity’s liquidation is imminent (at which point the entity must apply the liquidation basis of accounting).2
Before an entity’s liquidation is imminent, however, there is currently no guidance in U.S. GAAP about management’s responsibilities in evaluating or disclosing going concern uncertainties, nor is there any guidance about when and how such uncertainties should be disclosed in financial statement footnotes.3 Auditing standards and federal securities laws only require that an auditor evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time.4
The Proposed Going Concern Update
Earlier this year, the Financial Accounting Standards Board (“FASB”) issued a proposed Accounting Standards Update, Presentation of Financial Statements (Topic 205): Disclosure of Uncertainties about an Entity’s Going Concern Presumption (the “Going Concern Update”). The proposed Going Concern Update is intended to provide preparers of financial statements with guidance about management’s responsibilities for evaluating and disclosing going concern uncertainties, and about the timing and content of such disclosures, thereby reducing inconsistency in footnote disclosures.5 An entity would evaluate going concern uncertainties by assessing the likelihood that the entity would be unable to meet its obligations as they become due within 24 months after the financial statement date.6 An entity would conduct the analysis at each annual and interim reporting period and start providing footnote disclosures when it is either (1) more likely than not that the entity will be unable to meet its obligations within 12 months after the financial statement date without taking actions outside the ordinary course of business or (2) known or probable that the entity will be unable to meet its obligations within 24 months after the financial statement date without taking actions outside the ordinary course of business.7 An entity would be expected to assess information about conditions and events that exist at the date the financial statements are issued, or for a non-public entity, the date that the financial statements are available to be issued.8 Mitigating conditions and events could be considered, but only to the extent they are within the ordinary course of business.9
When the above disclosure threshold is met, an entity would disclose in its financial statement footnotes a description of the following:
(1) The principal conditions and events that give rise to the entity’s potential inability to meet its obligations;
(2) The possible effects those conditions and events could have on the entity;
(3) Management’s evaluation of the significance of those conditions and events;
(4) Mitigating conditions and events; and
(5) Management’s plans that are intended to address the entity’s potential inability to meet its obligations.10
The Going Concern Update would apply to all entities, public and private.11 Additionally, an entity that is required to file with the Securities and Exchange Commission (“SEC”) would be required to evaluate and determine whether there is substantial doubt about its ability to continue as a going concern; if substantial doubt exists, the entity must disclose that determination in its financial statement footnotes.12
Potential Impact of the Proposed Going Concern Update
The proposed update could help to clarify the often murky and shifting fiduciary duties of officers and directors in troubled companies regarding the so-called “zone of insolvency” and “deepening insolvency” theories of liability. At present, the general rule (under Delaware law) is that those fiduciary duties—which are owed to the corporation itself—may be enforced by shareholders through derivative actions while an entity is solvent; when an entity becomes insolvent, however, creditors may commence derivative actions to enforce fiduciary duties.13 In bankruptcy cases, the new rule may also streamline fraudulent transfer and preference litigation; depending on the nature of the new disclosures, going concern footnotes could undermine or support a transferee’s good faith defenses. Bankruptcy practitioners will also note that the 24 month period matches the look-back period for fraudulent transfers under 11 U.S.C. § 548.
Many creditors, particularly lenders, will welcome the attempt to increase transparency, accuracy, and consistency in corporate financial disclosures. Less clear, however, is the impact that the proposed Going Concern Update would have on investors, employees, local communities, and other constituencies. At present, creditors and investors are free to draw their own conclusions from an entity’s financial disclosures on that entity’s ability to continue as a going concern. However, an express statement from management that it is “more likely than not” that an entity will be unable to meet its obligations in the near future could very well accelerate an entity’s looming financial collapse, thereby tying management’s hands and prematurely dooming a troubled, but still viable, company. All four of the major auditing firms have cautioned that the proposal could lead to more bankruptcies.14 A basic principle of American corporate governance is that management must be free to take reasonable risks in favor of shareholders15, at least until the entity is actually insolvent, at which point management must begin to consider the interests of the entity’s creditors, who take the place of its shareholders as the residual beneficiaries of any increase in value.16 If the proposed update enables entities, their creditors, and investors to better plan for an imminent financial restructuring, it will be a welcome change. All interested parties, however, should be cognizant of the potential for unintended negative consequences, including “self-fulfilling” bankruptcies, in the wake of the proposed disclosures.
1See FASB Exposure Draft, Proposed Accounting Standards Update—Presentation of Financial Statements (Topic 205): Disclosure of Uncertainties about an Entity’s Going Concern Presumption, p. 1, available at http://www.fasb.org/cs/BlobServerblobkey=id&blobnocache=true&blobwhere=1175827205763&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs.
5Id. at 2.
10Id. at 2-3.
11Id at 2.
13See, e.g., N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101-102 (Del. 2007).
14Liz Hoffman, Going Concern’ Analysis is Bankruptcy Crystal Ball: Study, Law360.com, Aug. 22, 2013, available at http://www.law360.com/articles/466937.
15See, e.g., Gagliardi v. Trifoods Int’l, Inc., 683 A.2d 1049, 1052-53 (Del. Ch. 1996); accord Weiss v. Temp. Inv. Fund, Inc., 692 F.2d 928, 941 (3rd Cir. 1982).
16Gheewalla, 930 A.2d at 101-102.