Issues in assessing the necessity for going concern uncertainty disclosure
Consider this simple hypothetical situation. At December 31, the end of its annual reporting period, an entity’s circumstances are sufficiently challenging that significant doubt exists about its ability to continue as a going concern. During the following January, the entity closes a major financing transaction, easily ensuring it can continue in business for comfortably more than twelve months. The entity issues its financial statements in March. Should those financial statements contain the disclosures required by IAS 1.25 about material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern?
The arguments on either side are probably obvious. On the one hand, such disclosure would accurately reflect the situation as it existed at the end of the reporting period. On the other hand, the specific “warning” that going concern disclosure usually provides for investors isn’t necessary here by the time the statements are issued. So which way to go?
Of course, this is just one of many hypothetical situations we could consider, and the extreme brevity of IAS 1 in this respect doesn’t provide much guidance. In 2012, IFRIC was asked to clarify some of these matters, and it tentatively decided to prepare a narrow-focus amendment to the standard; subsequently, the IASB considered the issue, and had the staff provide a discussion paper. The paper observed: “The assessment of going concern in IFRS is…a net one that takes into account both components: the events or conditions that cast doubt and any mitigating actions. This assessment results in a simple yes or no conclusion in IFRS—going concern is either an appropriate basis for the preparation of the financial statements or it is not.” The paper didn’t propose to change this basic approach to how the financial statements are prepared.
Regarding disclosure, the paper identified the following range of existing practice:
- “(a) No trigger for disclosure A few respondents to outreach think that, if management concludes that going concern is an appropriate basis for the preparation of the financial statements, any material uncertainties about going concern must have been resolved and disclosures are not required.
- (b) A net trigger for disclosure Some read paragraph 25 to mean that these disclosures are only required if, after taking account of mitigating actions, management think there is still a material uncertainty that may cast significant doubt upon an entity’s ability to continue as a going concern….
- (c) A gross trigger for disclosure Others read paragraph 25 of the Standard to mean that if there are any uncertainties about the events or conditions that could cast significant doubt upon the entity’s ability to continue as a going concern, disclosures must be made about the uncertainties identified in making the going concern assessment. Supporters of this view think that in making an assessment about the entity’s ability to continue as a going concern, management exercises judgement about material uncertainties with respect to both the events or conditions that cast significant doubts about an entity’s ability to continue as a going concern and about the feasibility and effectiveness of any planned or proposed mitigating activities. These respondents think that disclosure of the judgements involved in making these assessments is useful information for investors.”
The IASB staff supported this last view, judging that “IAS 1 should require that disclosure is triggered by the existence of the events or conditions that cast significant doubt upon an entity’s ability to continue as a going concern.” In my opening hypothetical situation, this seems to mean that the entity would include disclosure about going concern uncertainty, while also describing the “mitigating activities” that counteract this.
The problem with this, to me, is that going concern disclosures aren’t primarily about communicating operating risk, but rather about the integrity of the accounting. The Framework sets out the concept as follows: “The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed” (my emphasis).
The point of the italicized passage is that if the entity knows it’s going to (say) liquidate, then some of the values that would otherwise be included in the statements will make no sense – for instance, it will be obviously wrong to show carrying values for property, plant and equipment calculated on assuming an extended useful life. But the “if so” acknowledges that even if a liquidation is pending, the financial statements won’t necessarily have to be prepared on a different basis – for instance, if the balance sheet consists entirely of financial instruments measured at fair value for which no adjustment would be necessary. In this case, that passage of the Framework, read literally, wouldn’t require any additional disclosure; it would be indifferent in effect to whether a liquidation is pending or not.
Likewise, the key point in IAS 1.25 is about the relevance of existing uncertainties to assessing the recognition and measurement decisions taken in preparing the statements, not about their implications as a whole. This is logical because any number of reasons might exist why a particular set of financial statements might ultimately provide a poor guide to the future (subsequent changes in economic conditions, enhanced competition, departures in key personnel, and so on), but none of these possibilities would typically be highlighted there. That’s the importance of MD&A and other aspects of the continuous disclosure regime.
The IASB staff paper says: “Investors are interested in predicting future results and cash flows. Consequently, they are interested in information about any proposed mitigating actions, because these are likely to include significant future transactions, such as rights issues or asset sales, that cannot be anticipated from the underlying operating trends of the business.” But of course, such things are always of interest to investors, whether a going concern uncertainty exists or not. The staff’s line of thinking only leads to an incoherent situation where the financial statements of different entities might evidence drastically different approaches to highlighting and discussing risk, perhaps based on relatively minor distinctions in their risk profile. This is evidenced in the examples included within the staff paper, several of which seem subjective by any measure.
So if no significant risk exists for a particular entity, at the time it issues its financial statements, of the going concern basis of preparation being rendered inappropriate in the foreseeable future, it seems clear to me that formal going concern uncertainty disclosure isn’t helpful to investors in that entity – no matter how many “mitigating activities” it took to get there – because such disclosure would only seek to pull investors into the details of a specific technical determination which isn’t relevant to their decision-making. Of course the entity should disclose information about key risks and how it manages them. But frankly, there can be greater hidden risk to investors in investing in an entity with no going concern uncertainty (but subject to wide volatility) than in a horribly challenged entity (which might be little more than a penny stock anyway). So why should one situation carry a neon warning sign of disclosure, and not the other?
Anyway, the IASB decided not to go ahead with the staff’s proposal, or with any amendments to IAS 1 in this regard, although perhaps the subject will come up again as part of its ongoing disclosure initiative. In the meantime, the diversity in practice summarized above will presumably continue…
The opinions expressed are solely those of the author