Going concern is the assumption that an entity will be able to continue operating for the foreseeable future and carry out its obligations and objectives. It’s a somewhat ambiguous concept though, considering there are no generally accepted accounting principles (GAAP) to specifically, or 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:
The auditor evaluates an entity’s ability to continue for a period not greater than one year following the date of the financial statements that are being audited. Among other issues, the auditor takes into consideration the following to determine if there is substantial doubt about an entity’s ability to continue as a going concern:
Negative trends in operating results (ie: consecutive losses)
Default on any loans owed by the company
Denial of trade credit by company suppliers
Long-term commitments that may be economically unsound
Any legal proceedings against the company
The audit firm must then qualify any problems in its audit report with a statement about the issue.
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 likely already in question.So, how can we identify risk factors well in advance of an audit?
By the time the auditors report an issue, the financial trouble is already incredibly obvious, and it’s too late for investors or analysts. But financial data can indicate problems much sooner than an auditor would uncover the issue(s).
Let’s look at two examples of how financial data can raise a red flag:
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 showing that operating income, net income and cash from operations was declining way before 2015. Looking at the financial ratios it’s clear that this dire outcome could have been more clearly predicted several 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 already looking bad in 2014, during which time Stone Energy received a clean opinion.
So it’s clear that financial data can be an extremely valuable tool for uncovering red flags far in advance of devastating financial trouble. Once a problem becomes incredibly obvious, it’s too late for investors or analysts. By looking at historical financial data and the ratios themselves, declining trends can be identified much sooner to provide insights before the auditors raise the red flag.