The definition of a Going Concern, or an entity’s viability for the foreseeable future, has always been an ambiguous concept because there are no specific GAAP principles to objectively define it. Sure, there are standard metrics, but no agreed-upon requirements or checkboxes. There are, however, generally accepted auditing standards (GAAS) that instruct an auditor regarding the consideration of an entity’s ability to continue as a going concern:
“The auditor evaluates an entity’s ability to continue as a going concern for a period not greater than one year following the date of the financial statements being audited. The auditor considers (among other issues) the following items in deciding if there is a substantial doubt about an entity’s ability to continue as a going concern:
Negative trends in operating results, such as a series of losses
Loan defaults by the company
Denial of trade credit to the company by its suppliers
Uneconomical long-term commitments to which the company is subjected
Legal proceedings against the company
If there is an issue, the audit firm must qualify its the audit report with a statement about the problem.”
This usually means that it’s an auditor’s job to define going concern -- but by the time an auditor finds an issue, the company’s viability is already in question.
How can we identify risk factors well in advance of an audit? Financial data can often indicate problems that auditors won’t see for awhile. Here are two examples:
Synergy Pharma received a GC uncertainty opinion in 2015, but a 'clean' opinion in 2014 from the auditors. Below is a screenshot from the audit report in the 2015 10-K:
The redlined section reads "The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company has suffered recurring losses from operations and will continue to have large losses in the future that 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 2. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter. "
But here is a card that shows operating income, net income and cash from operations declining way before 2015. So, the financial ratios could have more clearly predicted this dire outcome a few years earlier:
Stone Energy received a going concern uncertainty opinion from the auditors in 2015 and a clean opinion in 2014. The doubt is raised in red:
The redline reads: "The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company could exceed the Consolidated Funded Debt to consolidated EBITDA financial ratio covenant set forth in its bank credit facility at the end of the first quarter of 2016, which would require the Company to seek a waiver or amendment from its bank lenders. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters also are described in Note 2. The consolidated financial statements do not include any adjustments that may result from the outcome of this uncertainty."
They mention this total debt-to-EBITDA in their 2015 10-K. Here is the trend:
In fact, the EBITDA-versus-Total Debt was looking bad already in 2014, during which time they received a clean opinion.
So it’s clear that by time the auditors report an issue, the financial trouble already incredibly obvious, and it’s too late for investors or analysts. By looking at the ratios themselves, any financial data user can see declining trends well in advance of the auditor opinion and may provide insights before the auditors raise the red flag.