Liquidity Matters
How do I know when things have gone wrong?
Anyone who’s ever been involved in a startup or early stage company is likely familiar with the notorious ‘going concern’ disclosure. This type of disclosure can indicate serious trouble in a company otherwise expected to be financially healthy. But what does it mean? Is the company on the verge of collapse? Is it just management covering their posteriors with disclosure?
This eleventh post in my Deciphering Financial Statements for Non-financial Professionals series discusses how to understand going concern and liquidity disclosures in a company’s financial statements. In this series of posts, I provide insight into financial reporting and related topics geared toward non-financial professionals who are required to understand financial statements as part of their professional roles. I encourage you to also read the 6-Things-Every-Director-Needs-to-Know-About-Financial-Statements other instalments in the series, both past and future, particularly the introduction as that post establishes the series and includes a number of resources you may find useful.
What’s a ‘going concern’ disclosure?
Ironically, ‘going concern’ is actually a positive term in reference to a company’s ability to continue operations, defined as a company that has the internal resources necessary to continue to operate indefinitely. The going concern disclosure that may appear in a company’s financial statements is highlighting issues that indicate that the company in question may not qualify as a going concern.
International Financial Reporting Standards (IFRS) require management to make an assessment of their company’s ability to continue as a going concern at each financial reporting date. In such an assessment, management will consider a number of financial, operating and other events or conditions that, individually or collectively, may cast significant doubt about the company’s ability to continue as a going concern for the next year. A few examples of such items include, but are not limited to:
- Loans approaching maturity without realistic prospects of renewal or repayment or otherwise excessive reliance on short-term borrowings to finance long-term assets.
- Indications of withdrawal of financial support by creditors or inability to pay creditors on due dates.
- Negative operating cash flows, substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
Inability to comply with the terms of loan agreements or non-compliance with capital or other statutory requirements.
- Loss of: key management (without replacement), a major market, key customers or principal suppliers or the emergence of a highly successful competitor.
- Labor difficulties or shortages of important supplies.
- Pending legal or regulatory proceedings against the company that may, if successful, result in claims that the company is unlikely to be able to satisfy.
- Changes in law, regulation or government policy expected to adversely affect the company.
- Uninsured or underinsured catastrophes.
Should a company’s management conclude events or conditions that threaten the company’s ability to continue as a going concern are present, they are obliged to disclose these issues in their financial statements. Hence, this disclosure should comprise a concise list of relevant issues impacting the company that could potentially cause it to cease operations in the foreseeable future.
Is there judgment to be applied in a going concern evaluation?
There is a spectrum of circumstances that may be considered when determining whether a material uncertainty exists and there may be a ‘gray area’ where judgment is required to determine whether a going concern problem is present. The following graphic, applied in the context of a mineral exploration company, demonstrates the spectrum of issues that may be present and that management may consider when determining whether a material uncertainty exists, with the left side clearly indicating a material uncertainty and the right representing a situation where there is clearly not a going concern problem.
It is important to note that such disclosure is common for pre-operating companies, such as in the case of mineral exploration companies, and its presence is not necessarily an indication that the company is going to go under tomorrow. Startup companies in particular are often set up in a manner that allows them to go dormant or otherwise maintain basic operations with low levels of capital as this is a real business risk that management can often anticipate and plan for. An investor in such companies should take this risk into account and understand that there is never certainty with such highly speculative businesses. The key here is to understand specifically why management concluded that the company’s viability is at risk and make an assessment based on the severity of those risks in the context of the company’s business plan.
Where else can I find meaningful information regarding a company’s liquidity?
Particularly where a company has disclosed a going concern threat, a financial statement reader may be interested in understanding the threats better, which generally relate to liquidity and sustainable operations. The following information may be useful in such situations:
- Liquidity disclosure in the financial instruments note: this disclosure should provide details of the company’s liquidity risks, including maturity dates of liabilities.
- Financial ratios: much useful information can be gleaned from comparing and understanding such ratios, particularly when compared over periods of time. Refer to my article on this issue.
- The statement of cash flows: this statement is often underutilized by financial statement readers but when it comes to understanding liquidity, it’s an excellent tool. Refer to my article on how to understand this statement.
- Other documents: if the company in question is publicly listed, management will publicly file documents that provide more detailed insight into their plans and operations that may not be in the financial statements. In Canada, the Management’s Discussion & Analysis (MD&A) or Annual Information Form are valuable tools in this regard.
How does the going concern disclosure impact the auditor’s report?
Where a company’s financial statements are audited and a going concern issue is disclosed, the auditor is obligated to highlight management’s disclosure and the reasons for it in their auditor’s report. This is accomplished through the inclusion of an ‘emphasis of matter’ paragraph in the auditor’s report which is not considered a qualification of the report.
In cases where the auditor disagrees with management’s conclusion on the adequacy of going concern disclosures and the issue cannot be resolved, the auditor may provide an adverse or qualified opinion, although the latter would be challenging due to the pervasive nature of a going concern problem.
What if a company doesn’t qualify as a going concern?
A company’s management is required to prepare the financial statements on a going concern basis unless they either intend to liquidate the company or to cease trading, or have no realistic alternative but to do so. Should a company find itself in this dire situation, liquidation basis accounting may be applied. IFRS provides no specific guidance regarding this basis of accounting, however this approach essentially requires the revaluation of assets and liabilities at amounts expected to be realized through the liquidation of the company and related supporting disclosures and presentation changes.
If things do start to go wrong, it’s important to understand the risks and indications where liquidity issues start to look serious. Refer to my article on key financial statement issues, some of which may be highly relevant in such situations.
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