REPORTING ON GOING CONCERN BEFORE AND AFTER SAS NO. 59

By Marshall A. Geiger, K. Raghunandan, and D.V. Rama

One of the continuing expectations of investors and other financial statement users is an early warning signal for companies in financial distress. Accordingly, there is an ongoing call to auditors to "red flag" those companies for which bankruptcy is inevitable or at least highly probable.

Prior audit reporting requirements under SAS No. 34 required a "subject to" qualified audit opinion in cases where the company's ability to continue in existence was in doubt. The former professional standards did not require auditors to explicitly evaluate a client company's ability to continue in existence as part of each and every audit. Continued existence was assumed and not specifically substantiated in most audits. The reporting and auditing requirements under SAS No. 58, and particularly SAS No. 59, which addresses the auditor's consideration of an entity's ability to continue as a going concern, require an explicit evaluation of a company's continued viability in every audit. For cases where such viability is in substantial doubt, a modified (but still considered unqualified) report is to be rendered with an additional fourth paragraph describing the uncertainty about the entity's ability to continue in existence for a reasonable period of time. The following is an example of such an explanatory fourth paragraph set out in SAS No. 59:

The accompanying financial statements have been prepared assuming that the company will continue as a going concern. As discussed in Note X to the financial statement, the company has suffered recurring losses from operations and has a net capital deficiency, which raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note X. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

Financial statement users have consistently expected auditors to render such early warning signals under the premise that auditors are in the best position to determine when companies are in a situation of potential failure and report this doubt to interested parties. With changes in audit standards that both require a closer look at a company's ability to continue and alter the reporting of any resultant substantial doubt, comes the necessity to evaluate whether the new standards have actually been successful in their attempt to more closely meet user reporting expectations.

In an attempt to provide information to make such an evaluation, a study was conducted that examined auditor reporting tendencies regarding subsequently bankrupt companies after the new SASs and compared them to pre-SAS No. 59 findings. If auditors are found to render more going-concern opinions for subsequently bankrupt companies following SAS No. 59 than before, the new standards can be said to have improved auditors' reporting actions and closed the expectations gap at least to some extent regarding reporting on bankruptcies.

Review of Audit Reports

Past Reporting Practice. Prior research using pre-SAS No. 59 audit reports have consistently found that only about 40 to 45% of bankrupt companies received a "subject to" qualified audit report on their financial statements for the year immediately preceding bankruptcy. If there was no change in auditor reporting tendency after SAS No. 59, we would expect a similar percentage of bankrupt companies to receive a SAS No. 59 explanatory paragraph for going concern.

New Reporting Practice. To examine audit reporting under SAS No. 59, we examined prior audit reports given to recently bankrupt companies. The Predicast Index of Corporate Change for the years 1990 through 1992 was used to identify bankrupt companies. Financial and audit report data on these companies were collected from immediately preceding financial statements.

This search yielded 93 bankrupt companies for the period that included all necessary information. We also wanted to examine the auditor reporting behavior under various degrees of reported financial distress of the bankrupt companies. Accordingly, we examined three widely used measures of financial distress that were used in prior studies and were also identified in SAS No. 59 as distress signals: 1) recurring negative cash flow from operations (i.e., negative cash flow in the current and prior year), 2) recurring losses from operations (i.e., losses in the current and prior year), and 3) a negative working capital position. Each of the three measures was given a "1" if present and a "0" if not. These financial distress indicators were then added together to give an overall reflection of the relative level of reported financial stress just prior to filing for bankruptcy. The levels of financial stress and resultant auditor opinions on these bankrupt companies are presented in the Exhibit.

Study Results

The overall results indicate that 62% of the bankrupt companies for the period properly received a SAS No. 59 going concern modified audit report in the year prior to bankruptcy. This is a considerable increase over the 40 to 45% found in earlier studies of auditor reporting behavior prior to SAS No. 59. These findings indicate that the new SAS's requirements regarding auditor responsibility to evaluate and report on issues of client's ability to continue as a going concern appear to have been fruitful. The increased percentage of failed companies receiving a going concern audit report has increased substantially after the new standards.

Regardless of whether the results are due to the new requirement to more actively evaluate the client's viability in every audit or due to the elimination of the former "subject to" qualified report, the new standards have appeared to improve audit reporting. More bankrupt companies are receiving going concern audit reports prior to bankruptcy, thus narrowing any existing expectations gap in this regard.

The Exhibit also indicates the increased tendency to give a going concern modified report comes when two or more of the examined financial distress indicators are present. Of those bankrupt companies with two or more distress indicators, 26 out of 31 (84%), received going concern reports prior to bankruptcy. Of those companies exhibiting none or only one financial distress indicator, 32 out of 62 (52%), received a report modification.

These results (82% and 52%), however, compare favorably with the former findings of roughly 40 to 45% for all bankrupt companies and provide evidence auditors are more apt to issue the new going concern modified report in cases of financial stress and eventual bankruptcy. SAS No. 59 reporting requirements, although signalling the same event as prior standards, appear to have caused or enabled auditors to more accurately and timely report on the financial condition of client companies to third parties.

Room for Improvement

Although these findings show considerable gains in reporting on the ability to continue as a going concern, they also indicate considerable room for improvement, particularly when few or no typical financial statement distress signals are present. In these situations, only about half of the eventually bankrupt companies received modified audit reports in the year immediately preceding bankruptcy.

SAS No. 59 requires auditors to look at client managements' plans, strategies, and ability to overcome any financial and business stress. Auditors must also assess other circumstances and events within the client organization, as well as those of related companies, other companies in the industry, and the economy in general. Auditors must closely monitor all events that affect the client's financial viability‹even prior to when significant levels of financial stress are reflected in the financial statements. These critical evaluations are essential to allow auditors to make an accurate assessment of the client's ability to continue, and thus enable a more accurate and timely reporting on continued viability.

Auditors' assessments of continued existence are constrained by the availability and accuracy of information. As stated in SAS No. 59, auditors are not responsible for predicting future conditions or events. Auditors are, however, responsible for understanding and assessing existing conditions or trends that may lead to financial stress and eventual business cessation. Professional and business knowledge and judgment play important roles in these required evaluations. A more critical or thorough approach to continued existence evaluations under SAS No. 59 would enable auditors to further increase their effectiveness in reporting on going concern problems, particularly in situations prior to their manifestation in the financial statements. A closer adherence to the intent, as well as the letter of auditor responsibilities embodied in SAS No. 59 would undoubtedly raise audit reporting accuracy above the already increased levels found in this study. *

Marshall A. Geiger, PhD, CPA, is an associate professor of accounting at the University of Rhode Island. K. Raghunandan, PhD, and D.V. Rama, PhD, are associate professors of accounting at the University of Massachusetts at Dartmouth.

EXHIBIT

SAS NO. 59 REPORTING FOR BANKRUPT FIRMS (1990­1992)

No. of Financial Unmodified Modified Percent of
Stress Indicators Report Report Total Total

0 13 13 26 28%

1 17 19 36 39

2 4 25 29 31

3 1 1 2 2

Total 35 58 93 100

Percent 38% 62% 100%

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

AUGUST 1995 / THE CPA JOURNAL53