Posted by: David Henry on June 16
The Financial Accounting Standards Board is working on a new rule that would clearly require companies to tell investors when there is a substantial doubt that their company will continue as a going concern. That seems only fair. If there’s anything investors should know it is that a company is in danger of failing.
But saying “substantial doubt” with “going concern” is about as easy for company executives and directors as calling a priest to administer last rites. The phrases are loaded because they are known for appearing in auditors’ opinions of financial statements right before a company croaks.
In fact, it is not even clear that FASB really wants to make companies use the words. FASB, the keeper of generally accepted accounting principles (GAAP), put the issue on its agenda two years ago but still doesn’t have a rule out. It did have a draft nearly ready to go on June 3, but the board sent it back to the staff for revisions. Back in 2000, when dot-com companies were vaporizing without warning, a blue-ribbon panel of accounting and auditing experts called on FASB to require companies to acknowledge such imminent dangers. The next year the chief accountant of the Securities and Exchange Commission wrote a follow-up letter to FASB to urge the board to get on with it. It hasn’t happened.
It is too bad that nothing got done in the years before the credit bust. Scores of companies are defaulting now because they took on debt in the boom that they can’t repay. The default rate for U.S. speculative grade companies reached 10.2% in May, up from 2.2% a year ago, according to Moody’s Investors Service. Moody’s predicts the rate will top out later this year at 13.5%.
Right now the only U.S. standards for clearly disclosing that a company is headed toward failure are in rules for auditors. Auditors are required to evaluate a company’s viability because financial statements are built on assumptions that a company will continue. If the company may have to start liquidating, then the auditors have to qualify their opinion of the financial statements.
For widely-followed companies, “going concern” opinions from auditors always seem to come as old news. General Motors had a going concern letter from its auditors in the annual report it filed March 5. That was three months after Standard & Poor’s rated General Motors CC for creditworthiness. Historically, one-fourth of companies rated CCC to C by S&P default within one year. GM filed for bankruptcy on June 1, three months after its auditor’s letter.
Why the opinions from auditors seem to show up late is a matter of debate. One widely assumed reason is that companies will fight auditors who challenge them to prove that there doubts can be overcome. If FASB were to make it clear that companies themselves are responsible for disclosing substantial doubts, the companies would probably less likely to fight and auditors would be more likely to call a spade a spade. A requirement from FASB would also remind executives that they have primary responsibility for getting financial statements right in the first place, not the auditors.
Whether FASB gets a rule in place or not, experts say the debt boom and bust will force more corporate directors to at least talk about going concern doubts. How many more depends on how quickly the credit markets heal. But it will happen in cases where it is doubtful that banks or the credit markets will refinance debt that companies have coming due. And, some companies may find that losses on assets in the recession have thrown them below net worth requirements in their debt contracts. Those sorts of breaches can trigger defaults. “You can have a company that is profitable on paper, with positive cash flow, and the directors still need to have going concern discussions,” says Catherine Bromilow, a partner in PricewaterhouseCooper’s corporate governance practice. This is a change from the past when going concern issues tended to come up only after years of losses made them obvious to all. “It is just a different dynamic,” says Bromilow.
Still, investors may never know these discussions are taking place. Companies are much likely to say more specific risks than describe their likelihood of coming to pass. For example, companies are more likely to say that they might not be able to refinance than they are to label that risk with a red letter warning like “substantial doubt.” The term itself can cause the worst sorts of trouble. “A going concern opinion is a huge black cloud over a company that could become a self—fulfilling prophesy” by causing lenders and suppliers to withdraw credit, says Bromilow. “These conversations don’t happen lightly.”
So, what’s true before is still true: If you don’t already know a company is in big trouble, don’t expect the executives and directors to tell you.
BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.