A European issue with going concern disclosures in interim statements

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 18^th edition:

• “Significant doubts were cast upon an issuer’s ability to continue operating as a going concern due to weak profitability in combination with a high debt-to-asset ratio. The issuer was in breach of several loan covenants, and its liquidity situation was challenging. The uncertainties regarding the issuer’s ability to operate as a going concern were disclosed in the notes to the 2013 annual financial statements.
• However, in its interim financial statements as of 31 March and 30 June 2014 the issuer did not include a sufficient and complete assessment of the going concern assumption or associated issues, inter alia, breach of covenants and an updated liquidity risk assessment.
• In the interim financial statements as of 30 September 2014 the issuer included disclosures regarding the material uncertainties related to its ability to continue as a going concern, as required by paragraph 25 of IAS 1…”

The enforcer (as ESMA likes to term it) concluded that the disclosures of going concern uncertainty and liquidity risk were insufficient in the March and June 2014 interim statements, citing the requirement in IAS 34.15 for an issuer to provide “an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period.” Insofar as it applies to going concern disclosure, this may seem too obvious to be worth commenting on – disclosures on this topic might be regarded as among the most decision-critical there is. And yet, I wonder if this was worth the effort on the enforcer’s part.

The entity, as noted, had already disclosed significant doubt in this regard in its 2013 annual statements, and in the absence of any statement to the contrary, readers would assume this condition persisted into the interim periods. Of course, that rationale alone wouldn’t inform a reader of changes in the circumstances underlying the assessment. But financial statements aren’t a very effective place to address those circumstances anyway, compared to MD&A or similar documents. As I’ve written before, 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.

In the context of ESMA’s example, this suggests to me that if investors have already been informed about the risk that the going concern assumption might not be appropriate for a particular entity, there’s little value in fine-tuning that warning on a three-monthly basis. I’d argue IAS 34.15 doesn’t actually compel an issuer to do that, because the situation doesn’t in itself constitute a change in financial position and performance of the entity since the end of the last annual reporting period. Again, an increase in going concern uncertainty might flow from heightened risks of various kinds, but the most important thing there to investors should be the risks themselves, not the going concern implications (the ESMA example doesn’t give us any information on the adequacy of the issuer’s quarterly disclosures as a whole). As I also wrote before, 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 plainly 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.

This isn’t to say that the statements in this example couldn’t likely have been better. And I know that not everyone sees this the way I do. But if an entity’s already disclosed a going concern uncertainty, its investors should know to expect a bumpy ride from there on, and regulators’ technical fussing won’t do much to help them out on that…

The opinions expressed are solely those of the author