Auditing and Accounting Boards Should Work Together to Have Common Going Concern Standard, Former PCAOB Chief Auditor Says
September 6, 2023
After working on and off for a decade on a standard-setting project to consider revising the auditor’s evaluation and reporting of a company’s ability to continue as a going concern—or to stay afloat—the Public Company Accounting Oversight Board (PCAOB) is finally getting ready to issue a proposal in the coming months in 2023. And a former chief auditor of the PCAOB offered up a good piece of advice: the audit regulatory board and the Financial Accounting Standards Board (FASB) should work together and issue a joint proposal.
The joint effort is important because accounting and auditing standards contain different definitions. This means that company management and its external auditor have different ways of looking at whether the companies will be able to pay when debt comes due.
Currently, the accounting standard-setter does not have going concern on its technical agenda.
“I think the PCAOB and the FASB have to work together to resolve the going concern issue,” said Marty Baumann, who was the chief auditor of the PCAOB from 2009 to 2018.
“And together, they should both put out a common reproposal by the FASB on their existing standard and a proposal by the PCAOB to amend their standard to whatever it is they come up with,” said Baumann, an adjunct professor with The Washington Campus. “But it needs to have one common solution.”
In particular, under PCAOB standards and federal securities laws, auditors have a responsibility to evaluate whether there is a “substantial doubt” about whether a company will be able to continue to operate. If there is, the auditor needs to report it in the opinion section that is part of a public company’s regulatory filing. U.S. GAAP requires management to alert investors if they have “substantial doubt” about the company’s survival. The FASB defines substantial doubt using a threshold of “probable” that a company will not be able to pay debts as they come due during the next 12 months.
The auditing standard is based upon a qualitative threshold that the auditor would evaluate using a broader number of factors than the FASB’s. No definition of “substantial doubt” exists in PCAOB standards. The auditor’s evaluation does not necessarily have to rise to the level of the “probable” threshold that the FASB set.
Because management and auditors have different going concern thresholds, the PCAOB staff have been examining financial statements filed with the SEC to look at both the management’s disclosures and the auditor’s going concern opinions. In some cases, auditors reported substantial doubt while management did not make the disclosures.
History and Background
The PCAOB has been considering changing its going concern standard because in part its external advisers said that the audit standard does not work properly.
After the bursting of the dot-com bubble, auditors issued their going concern assessments well after the stock price reflected the market’s awareness of the company’s imminent collapse. In the 2008 financial crisis, several large financial companies collapsed, two of the nation’s Big Three car makers had to be rescued by the federal government, and the pain was felt throughout the economy.
The failures happened with little to no advance warning from the companies involved. Since then, regulators had sought to change the accounting and auditing standards and reporting rules to produce a better warning system.
Fifteen years ago, there was already an auditing standard in place but not an accounting standard. While the PCAOB was debating how to change the going concern standards since the 2008 financial crisis, the FASB came up with its own going concern standard in 2014, which some say is too liberal and inadequate.
The difference between the audit standard and the FASB’s guidance prompted the PCAOB to release a staff practice alert to emphasize that the current audit standard remains in effect.
Auditors: Keep FASB’s Standard
Now as the PCAOB is working to change its going concern standard, auditors also want to see common accounting and auditing standards. But they prefer the FASB’s standard.
During a meeting of the PCAOB’s Standards and Emerging Issues Advisory Group (SEIAG) in the spring, representatives of the auditing profession pushed for alignment with the FASB’s definition. Moreover, some auditor representatives said the PCAOB’s auditing standards on estimates and use of specialists should be aligned with the board’s risk assessment standards to drive higher quality audit.
The going concern standard “should not be something in addition to what is already required in GAAP, but that it should align to the financial reporting framework,” said Steven Morrison, a partner with CohnReznick LLP.
“And I think there’s a lot that’s in there about the estimates and so forth where it gets to the auditing, but also [FASB’s] ASC 275, Risks and Uncertainties, …that these financial statements appropriately tell the story of what’s out there,” he said. “So just because that maybe there is substantial doubt that’s been raised and it’s been alleviated, you also have your risks and uncertainties disclosures that kind of serve what I am hearing people talk about in terms of that early warning.”
Brian Croteau, a partner with PricewaterhouseCoopers LLP, explained that when the FASB decided on the going concern standard, it was done in “close coordination with the SEC.”
The Securities and Exchange Commission, as the capital markets regulator, oversees both the FASB and the PCAOB. The commission has more explicit oversight of the PCAOB as it must approve the board’s standards before they become effective. There is no explicit approval process for the FASB, but the commission still will have the last say if necessary. After all, the SEC has investigative and enforcement powers over companies that the FASB does not.
Croteau did not provide a disclaimer that he was a deputy chief accountant at the SEC from 2010 to 2016, which included active going concern discussions. His key role at the time was to help the commission oversee the PCAOB. But there is a close coordination between the SEC’s chief accountant and another deputy chief accountant who focuses on accounting issues and helps the SEC oversee the FASB.
“It’s important to look back to what the SEC’s requirements are for auditors and” the securities laws, Croteau continued. “There’s very, very specific obligations for auditors to execute procedures and form … independent conclusions. And I think the FASB landed in close coordination with the SEC on ‘probable’ and that to some is more of a red flag than an early warning. So, I think the use of those words, it’s important to be careful. I also think the points around sort of where one would look at an investor to understand liquidity and risk, I mean, obviously, U.S. companies have disclosure requirements and obligations around risk factors and liquidity that are going to be much more robust and timely than the ones that the audit reports issued and a much different kind of level of thresholds and in detail, so I think that’s important to keep in mind.”
Investors on Alignment with FASB’s Standards: Not So Fast
However, investors had different ideas. They want stronger FASB and PCAOB standards, though currently audit standards are stronger. For example, when the PCAOB was actively researching the issue before it got temporarily removed from the standard-setting agenda later on, the staff examined 2016 financial statements and found that in 13 percent of the cases, auditors reported substantial doubt, while management did not make the disclosures.
Former SEC chief accountant Lynn Turner, a strong investor advocate, at the SEIAG meeting explained that the debate concerning substantial doubt has been going on for 50 years.
“And no one’s ever really done it any real justice. Some of the firms will say it’s probable and that means it’s a 75 percent. I have seen one of the Big Four firms manual actually quantifies it at 75 percent,” Turner explained. “Although you will never see the FASB agree to that or say that’s the number. But this was the point that the investor advisory group made back when it was looking at this issue.”
Then Turner said that about a decade ago, a CFA Institute survey found that the going concern assessment should not be so black and white because it is subject to judgment.
“The CFA Institute, the people that we actually use the financial statement, said ‘let’s do this in increments. We want some earlier disclosures. And then as issues start to pop up on the horizon, and then enhance and increase that level if those conditions and situations continue and trend in a negative fashion until you get to the point that you know, they very well may not make it or which time you get to the going concern disclosures by the FASB and then appropriate disclosures by the auditing standards,” he said.
Turner explained that when the FASB was drafting its going concern standard, the chief auditor of the PCAOB at the time—Martin Baumann—“did not want to redo the standard because they felt that the FASB standard actually didn’t meet what investors said they were looking for and rejected that notion…. At the same time, investors didn’t embrace” it.
Sandra Peters, senior head for global advocacy for CFA Institute, emphasized that investors “are looking for warnings of risk, not the cliff is right here.”
“And I think some of the situations over the last year with the impact of interest rates is an example of disclosures with financial statements that we needed to educate both investors and the auditors about those asset liability mismatches. That would have made it more obvious with respect to if there was emerging interest rate risk and how did that get incorporated into the liquidity risk,” Peters said. “But when I look at the actual standard, a lot of the language seems to me to be heavily internally focused analytical procedures, review of subsequent events. The consideration of conditions and events does go to possible future events, negative trends, but a lot of those are ratios that are internal and possible financial difficulties, and it talks about internal matters. And there’s one bullet on external matters that occurred: legal proceedings, legislation, similar matters, loss of franchise license, loss of principal customer, etc. It doesn’t necessarily consider market conditions. Having been an audit partner and having been… a controller, there’s a lot of conversations that the auditors aren’t a part of. And management has vastly more information about how the business behaves relative to the economic conditions that exist than do the auditors.”
Dane Mott, an accounting analyst with Capital Group Companies, said that he believes the FASB should remove the 12-month outlook.
“We get these schedules where companies are saying what their payments are, their contractual payments are out for several years,” Mott said. “So, if you know there’s concern in year two, year three, year four, that’s still relevant and it should come in.”
Turner again said, do “not tell us when we are going to go over the cliff. Tell us when investors want to hear when are we starting to head towards the cliff. And then tell us as we proceed if we are getting closer and closer to the cliff. We don’t want to be in the car with Thelma and Louise. And right now, that’s where we are.”
An early warning system is needed because the FASB “rejected what investors asked for, or at the PCAOB in a standard that was written by the profession 40 years ago, you know, when they started doing this, so it’s not in one or the other,” Turner added.
The Sarbanes-Oxley Act of 2002 created the PCAOB after accounting scandals at companies like Enron and WorldCom two decades ago, which wiped out an estimated $85 billion of investor money. When Enron failed, it was the largest bankruptcy in the United States at the time. Before the PCAOB was established to regulated public company audits, the AICPA set its own rules for accountants. The association still writes auditing standards for private companies today.
The objective of going concern projects should be “how do we create a system” that serves investors,” Turner said.
The PCAOB has a single mission: investor protection.
In the meantime, Baumann said that it would be unwise for the PCAOB to move ahead by itself and change its standard to align with that of the FASB’s.
“I would also be unhappy if the PCAOB went ahead with the proposal by itself and moved forward with FASB definition of substantial doubt, as I think that’s completely inconsistent with the intent of the legislation that requires that set of requirements for going concern reporting,” Baumann said.
When asked to comment, both the PCAOB and the FASB carefully sidestepped the issue of a joint proposal. Thomson Reuters is not aware of a common proposal in the past.
“The PCAOB is actively working to update the going concern standard to ensure investors are best protected and we welcome input from all stakeholders throughout that process,” a PCAOB spokesperson said.
“The FASB completed a project to improve financial reporting of Going Concern uncertainties in 2014. That project included extensive outreach with stakeholders,” a FASB spokesman said. “The FASB does not have a current project related to going concern uncertainties.”