“The one real tool at the auditors’ disposal – a going concern opinion – was rarely used.”(1)
Steven B. Harris, board member, PCAOB
Global financial reporting is in limbo, in appearance and in fact. Among the current regulatory divergences, perhaps one of the most pressing issues is going concern assessment due to its ubiquitous presence in extant regulations, including the assumption of going concern in Pillar 2 economic capital adequacy assessment in Basel III and Solvency II.
In an analysis of the ICAAP practices of 19 European banks – “Mastering ICAAP: Achieving Excellence in the New World of Scarce Capital” – McKinsey concludes that an understanding of the “going concern” and “gone concern” concepts, among other things, is essential. However, McKinsey’s discussion with the banks also shows “little consensus on the precise distinction between the two scenarios despite the fact that the choice of scenario is the foundation of a bank’s capital-adequacy framework and is currently at the center of regulators’ attention.”
As a focal point of audit reform, going concern assessment has received increasingly intensive regulatory attentions since the 2008 financial crisis. The PCAOB and the FRC (UK) each issued practice alerts on going concern issues in late 2008 and again in late 2011 and 2009 respectively.(2) In addition, the two audit oversight agencies launched separate independent studies on going concern assessment.(3) In the inaugural Roundtable of Financial Reporting Series of the SEC on November 8, 2011, entitled “Measurement Uncertainty in Financial Reporting”, going concern issues were also extensively discussed.
What Are Going Concern Issues?
Historically used as a regulatory compliance tool, the accounting concept of going concern has been the explicit foundation of modern finance. Accordingly the assumption of going concern is embedded in all facets of capital market activities, including financial regulations, corporate finance theory, valuation techniques and bankruptcy resolution practices. However, the integrity of the going concern concept and its binary “pass or fail” structure has been subverted by the “information uncertainty”(4) issue of a principle based fair value accounting regime. The combined forces of marked to market practice, illiquidity, volatile market and adverse economic conditions can easily push an otherwise solvent company quickly into the abyss of insolvency, rendering going concern opinion almost useless to users of financial information.
The difficulties in converting a going concern compliance tool to a going concern risk reporting and disclosure tool for insolvency early warning lie in the binary “pass or fail” model as well as the prevalent use of probability phrases and words in going concern assessment, such as “substantial doubt”, ‘significant doubt” (IAS 1), “more likely than not”, “reasonably likely” and “imminent”. Ponemon and Raghunandan (1994) conducted a survey that examined statistical interpretations of “substantial doubt” in going concern assessment by a group of stakeholders that included 45 auditors, 95 bank loan officers, 88 financial analysts and 32 judges. It was found that the judges were the most conservative in going concern assessment with the mean (median) probability value of 0.33 (0.30) assigned to “substantial doubt”; followed by the auditors 0.57 (0.51); financial analysts 0.71 (0.70); and the bank loan officers 0.72 (0.75).
Therefore the going concern issues during the current economic conditions can be summarized as follows:
(a) Inconsistent statistical interpretation of probability phrases used to define insolvency in going concern assessment by different groups of financial information users.
(b) Globally divergent accounting and audit guidance on going concern assessment.
(c) Going concern assessment is not risk sensitive: a “BB+” credit rated company would be as much of going concern as an “AAA” rated company and going concern assessment does not provide incremental information as a company approaches insolvency. It is not sensitive to liquidity risk stemming from measurement uncertainty and volatility in financial reporting, such as fair value estimates of level II and III financial assets and liabilities.
(d) Binary “pass or fail” model that does not measure the gradation of going concern risk from “going concern” to “gone concern” in continuum.
Could Going Concern Assessment be Used as Insolvency Early Warning?
According to Steven Harris’ statement on Concept Release on Possible Revisions to PCAOB Standards Related to Report on Audited Financial Statements, the eight bankrupt companies without going concern modifications to their financial statements in the wake of the 2008 financial crisis lost 99% going concern value, from $75.5 billion to $700 million. In addition, fixed income investors may suffer even bigger losses, potentially in the range of $200 billion in debts issued by these eight companies prior to their bankruptcy filings. “Yet, the one real tool at the auditors’ disposal — a going concern opinion — was rarely used,” said Mr. Harris.
The intent of the going concern guidance in IAS 1 of the IFRS appears to be for insolvency early warning, with essential features such as management primary responsibility for going concern assessment and time horizon “at least but not limited to” 12 months. In fact, FASB initially pursued the same approach as outlined in the exposure paper on Going Concern in October 2008 that would write going concern assessment into the GAAP with going concern guidance converged with that of IAS 1 and would require certain early warning disclosures.
But three years later, FASB decided to go the opposite direction by announcing on January 11, 2012 that going concern assessment is not a management primary responsibility. As a result of this drastic departure, the AICPA decided to postpone convergence of its audit guidance for going concern, SAS 59, with International Standards of Auditing (ISA) 570 of the IAASB until further development in the Disclosures about Risks and Uncertainties and the Liquidation Basis of Accounting (Formerly Going Concern) project of the FASB.
Given the going concern issues during the current economic conditions and divergent going concern guidance in accounting and audit literatures, the current going concern audit model obviously could not fulfill the intended role in insolvency early warning.
Use of Going Concern Assumption in Financial Regulations
Pillar 1 capital is “gone concern” regulatory capital, which is assessed by stress testing at 99.98% confidence interval (CI) and assets are valued on liquidation basis. Pillar 2 capital is “going concern” economic capital, which is usually simulated at 80% CI for early warning that is mapped to triggers such as profit warning; and at 95% CI for financial distress that is mapped to triggers such as significant losses of capital.
However, such deterministic ICAAP approaches fail to pinpoint exactly where in capital structure a going concern would become a gone concern. While most Tier 1 capital instruments are well defined in terms of risk bearing, some Tier 2 components, such as going concern capital and cocos, are less clearly defined.
It appears that the going concern issues would likely pose challenges in reporting & disclosure consistency, such as calculation of Basel III capital ratios, trigger definition for bank hybrid capital and insolvency declaration of SIFI living will, especially for global SIFIs.
What is Going Concern Rating?
Going concern rating measures the gradation of going concern risk from “going concern” to “gone concern” in continuum on a rating (5) scale, which constitutes a pre-defined path to insolvency, and rates going concern risk and credit risk on the same rating scale with dynamic equity-debt notching. Going concern rating assesses insolvency risk in balance sheet test by measuring the relative volatility in valuation of assets and liability as well as in cash flow test by measuring the relative volatility in cash flow and obligations.
Equity-debt notching signifies the actual allocation of and potential claims on cash flow between equity and debt holders and defines the notching differentials between going concern rating and credit rating. It can swing quickly, either in favor of shareholders or creditors, by materialized “potential claims on cash flow”, such as “in the money” options, credit rating downgrades or margin calls.
Zone of insolvency is a relatively new legal concept that defines corporate governance practice and directors’ duties when a company is “approaching” the “vicinity of insolvency”. The boundaries of zone of insolvency are defined by going concern ratings and the width would change subject to the level of certainty (or uncertainty) of a company’s financial reporting. In zone of insolvency, creditors usually have more cash flow allocation than shareholders and therefore have higher cash flow priority, and accordingly credit rating would be 1 to 5 notches higher than going concern rating.
Going concern rating conveys three critical pieces of information in measuring going concern risk in continuum: exposure-based probability of insolvency; equity-debt notching that signifies cash flow priority via actual allocation of and potential claims on cash flow between equity and debt holders; and zone of insolvency that measures the level of uncertainty in financial reporting. For example, a company with a high going concern rating and a wide zone of insolvency suggests that the strong balance sheet and cash flow of the company during the current favorable market conditions is susceptible to surge in market illiquidity because of the high level of uncertainty in financial reporting and valuation assumptions. Hence, the company has a “short distance to insolvency”.
Proposed Use of Going Concern Rating in Financial Reporting Supply Chain
Given the lingering regulatory impasse on going concern guidance and the ubiquitous presence of going concern assumption in all facets of capital market activities, it is time to consider incorporate going concern rating into the global financial reporting supply chain as complement to statutory audit in going concern assessment and to credit rating in dynamic equity-debt notching analysis in zone of insolvency. As such, going concern rating, statutory audit and credit rating would form a new three-pillar structure that would significantly enhance the accuracy and efficiency in global financial reporting.
- By Simon Hu (simonhu66@gmail.com) – March 1, 2012
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1) Steven B. Harris, a board member of the PCAOB, made the comment in his statement on Concept Release on Possible Revisions to PCAOB Standards Related to Report on Audited Financial Statements, June 21, 2011.
2) PCAOB (2008) Staff Audit Practice Alert No. 3, Audit Considerations in the Current Economic Environment. PCAOB (2011) Staff Audit Practice Alert No. 9, Assessing and Responding to Risk in the Current Economic Environment. FRC/APB (2008) Bulletin 2008/10, Going Concern Issues During the Current Economic Conditions. FRC (2009) Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009.
3) FRC (2011) The Sharman Inquiry: Preliminary Report and Recommendations. PCAOB (2011) Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements and Related Amendments to PCAOB Standards.
4) “Information uncertainty” refers to measurement uncertainty and volatility in financial reporting, such as those embedded in assumptions used for fair value estimates of financial assets and liabilities, especially at level II and III.
5) Simon Hu (2011) Convergence of Audit and Credit Rating Practices: Going Concern Ratings. International Journal of Disclosure and Governance, 8, 323-338. Doi:10.1057/jdg.2011.15. http://www.palgrave-journals.com/jdg/journal/v8/n4/abs/jdg201115a.html
