Going Concern for Real Estate, Hospitality and Other Industries Under COVID-19
July 27, 2020
By Brian McFarlane
The global coronavirus pandemic has caused unprecedented uncertainty across most, if not all, industries. The direct impact and ripple effect of the economic fallout are expected to last for years. As such, there are many areas that both management and auditors need to review to ensure that companies can generate sufficient cash flows to support their operations and pay obligations within a 12-month period following an issuance report date (“look-forward period”), as well as maintain debt covenant compliance. Not since the 2008 housing crisis has there been a substantial increase in going concern audit opinions across all industries due to economic forces.
Management needs to understand its planning responsibilities in order to keep their companies profitable and cash flow positive. As management creates a plan to change their business model in order to alleviate cash flow issues, they will also need appropriate evidence and documentation to support their position and garner their auditor’s agreement with their conclusions.
Evaluating a going concern applies to financial statements for each annual and interim reporting period. This evaluation is based on relevant conditions and events that are known and reasonably (that a reasonable effort without undue cost and effort) knowable at the date of the financial statements are issued or available to be issued.
- Current financial condition, including a company’s liquidity sources, at the date the financial statements are issued or available to be issued.
- Conditional and unconditional obligations due or anticipated within the look-forward period.
- Funds necessary to maintain the entity’s operations considering its current financial condition, obligations and other expected cash flows within the look-forward period.
- Any other conditions or events that may adversely affect the entity’s ability to meet its obligations in the look-forward period.
If initial substantial doubt is raised, it is first management’s and then the auditor’s responsibility to evaluate whether management’s plans intended to mitigate the relevant conditions and events, when implemented, will alleviate the substantial doubt. In evaluating the mitigation plans, the auditor must determine if it is probable that the plan will be effectively implemented to the extent that it will mitigate the conditions or events that raised substantial doubt within the look-forward period.
Examples of Adverse Conditions
- Real Estate Specific
- A high number of vacancies and tenant defaults
- Significant increase of arrears
- Significant concessions or lease restructuring for commercial clients
- Hospitality Industry Specific
- Hotel closure
- Extremely low occupancy and room rates
- Loss of banquet, meeting, food and beverage revenue
- Loss of commercial tenants
- Loss of franchise
- Non-Industry Specific
- Breach of debt covenants
- Recurring operating losses
- Working capital deficiencies
- Negative cash flows from operations
- Default on loans
- Denial of trade credit
- Restructuring debt to avoid default
- Noncompliance with statutory capital requirements
- Disposing of substantial assets
- Seeking new financing sources or methods
- Work stoppages
- Loss of large clients or projects uninsured losses
Management’s Mitigation Plans
- Dispose of asset(s) or business segment(s) in order to raise cash
- Borrow or restructure debt
- Reduce or delay expenditures
- Furlough employees and layoffs
- Increase ownership contributions
Auditors’ Responsibility When Assessing Going Concern Uncertainty and Management’s Plans
- Remain alert throughout the engagement for evidence of substantial doubt, and modify risk assessments and planned procedures based on this information.
- Procedures that are performed should allow for an increase in management discussions, which should include management’s plans for addressing any potential going concern matters identified.
- Using a mindset of professional skepticism, challenge management’s plans to mitigate any instances of going concern based on if their plan is attainable and can be effectively implemented.
- Obtain written evidence of intent to support the company through the look-forward period.
- Assess the ability of a supporting owner or lender to actually meet the obligations stated to mitigate the risk of a going concern.
- In order to gain a clear picture of the company’s future, inquire with management about their evaluation of the company beyond the look-forward period.
- If after investigating the auditor concludes that substantial doubt does exist, modify the representation letter to discuss management’s plans to mitigate the adverse conditions, along with stating that the financial statements fully disclose all relevant matters.
- If substantial doubt exists, it must be disclosed whether or not alleviated by management plans.
- If substantial doubt is deemed to be alleviated due to plans management has put in place to alleviate the substantial doubt, the main conditions and events that raised the initial substantial doubt along with the plans must be disclosed in the financial statements.
- If substantial doubt is not alleviated by management plans, a statement in the footnotes indicating that there is substantial doubt about the entity’s ability to continue as a going concern within the look-forward period must be disclosed. An emphasis-of-matter in the audit or review report would be required.
- During the period in which substantial doubt no longer exists, there must be a disclosure as to how the relevant conditions or events that raised substantial doubt were alleviated.
Now, more than ever, it is important that auditors and management work together to monitor the impact of COVID-19 in order to properly plan, evaluate and mitigate the risk of a company’s ability to continue as a going concern. While management is ultimately responsible for overseeing and implementing this plan, the auditors should be sounding boards for plans that are formulated given the ever-evolving impacts of the pandemic.
Refer to the following professional standards related to going concern uncertainty requirements in audits and reviews of financial statements:
- ASC 205-40, Presentation of Financial Statements – Going Concern.
- PCAOB AS 2415, Consideration of an Entity’s Ability to Continue as a Going Concern.
- SAS No. 132, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern (Codified within AU-C 570).
- SSARS No. 24, Omnibus Statement on Standards for Accounting and Review Services – 2018 (Codified within AR-C Section 90, Review of Financial Statements).