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Going Concern Reporting – The Gap in GAAP Versus GAAS- Part Three

By: George M. Wilson & Carol A. Stacey

 

Our first two posts in this series have presented an example of a company (Sears Holdings) and auditor reporting requirements for going concern issues as well as reviewed reporting requirements for companies. In this last post we review reporting requirements for auditors and explore the gaps in more detail.

 

Auditor Requirements

 

For auditors of public companies the PCAOB did not change existing GAAS when the FASB Issued ASU 2014-15. Auditors follow this guidance in section AS 2415 of the PCAOB’s auditing standards:

 

02        The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (hereinafter referred to as a reasonable period of time). The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve audit objectives that are related to management’s assertions embodied in the financial statements being audited, as described in AS 1105, Audit Evidence.

 

02        The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (hereinafter referred to as a reasonable period of time). The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve audit objectives that are related to management’s assertions embodied in the financial statements being audited, as described in AS 1105, Audit Evidence.

 

The Gaps

 

There are gaps between what companies disclose and how auditors report. Two of the gaps are:

 

  1. The time period for going concern considerations, and

 

  1. The probability level for the company compared to the auditor for these disclosures

 

Time Period Gap

 

The auditor’s GAAS reporting requirement clearly states that the period over which going concern issues are evaluated is a “reasonable period of time, not to exceed one year beyond the date of the financial statements being audited”. The requirement under GAAP for companies is “within one year after the date that the financial statements are issued”. In practice, many auditors have actually used the period of one year after the financial statements are issued as their going concern disclosure threshold, but they are not strictly required to do this.

 

Probability GAP

 

The disclosure requirement for management in GAAP is that if it “is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued” then they must make disclosures. This threshold of “probable” has its roots in one of the earliest FASB standards (SFAS 5, now ASC 450) dealing with contingencies. This standard set out the definition of “probable” as:

 

“The future event or events are likely to occur”.

 

The auditor’s GAAS standard uses the probability threshold “substantial doubt”:

 

The auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time

 

So, what is the difference between “probable that an entity will not be able to meet its obligations as they become due” and “substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time”? This is of course a matter of judgment. Many practitioners would believe that probable is a higher threshold than substantial doubt. What is clear is that this is a subjective evaluation.

 

The PCAOB addressed this difference in their guidance about the new disclosure requirements. This language is from Staff Audit Practice Alert No. 13:

In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with the applicable financial reporting framework, including whether they contain the required disclosures, auditors should assess management’s going concern evaluation. In making this assessment the auditor should look to the requirements of the applicable financial reporting framework

In addition, auditors should continue to look to the existing requirements in AU sec. 341 when evaluating whether substantial doubt regarding the company’s ability to continue as a going concern exists for purposes of determining whether the auditor’s report should be modified to include an explanatory paragraph regarding going concern. The AU sec. 341 requirements for the auditor’s evaluation, and the auditor’s reporting when substantial doubt exists, have not changed and continue to be in effect. Under AU sec. 341, the auditor’s evaluation of whether substantial doubt exists is qualitative based 341.Accordingly, a determination that no disclosure is required under the ASC amendments or IAS 1, as applicable, is not conclusive as to whether an explanatory paragraph is required under AU sec. 341. Auditors should make a separate evaluation of the need for disclosure in the auditor’s report in accordance with the requirements of AU sec. 341.

 

This is of course another gap between GAAP and GAAS. Time will tell how the market reacts to this kind of presentation. And this explains why Sears Holdings disclosed their going concern uncertainty and their auditors did not modify their report.

 

There is one more interesting aspect to all this disclosure and auditor reporting discussion. What happens in a Form 10-Q where generally there is no auditor’s report?

 

The requirements in ASC 205-40-50 for interim periods are:

 

If conditions or events continue to raise substantial doubt about an entity’s ability to continue as a going concern in subsequent annual or interim reporting periods, the entity shall continue to provide the required disclosures in paragraphs 205-40-50-12 through 50-13 in those subsequent periods. Disclosures should become more extensive as additional information becomes available about the relevant conditions or events and about management’s plans. An entity shall provide appropriate context and continuity in explaining how conditions or events have changed between reporting periods. For the period in which substantial doubt no longer exists (before or after consideration of management’s plans), an entity shall disclose how the relevant conditions or events that raised substantial doubt were resolved.

 

Sears Holdings’ Form 10-Q for the first quarter of F/y 18 includes this disclosure:

 

We acknowledge that we continue to face a challenging competitive environment and while we continue to focus on our overall profitability, including managing expenses, we reported a loss in the first quarter of 2017, when excluding significant items noted in our Adjusted Earnings Per Share tables, and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions outlined above will further enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate, additional debt financing actions, and potential asset securitizations. We expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs.

 

We also continue to explore ways to unlock value across a range of assets, including exploring ways to maximize the value of our Home Services and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands through partnerships or other

means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including monetizing our real estate portfolio and exploring potential asset securitizations, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

 

We believe that the actions discussed above are probable of occurring and mitigate the liquidity risk raised by our historical operating results and satisfy our estimated liquidity needs during the next 12 months from the issuance of the financial statements. The PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the planned actions take into account the applicable restrictions under the PPPFA.

 

If we continue to experience operating losses, and we are not able to generate additional liquidity through the actions described above or through some combination of other actions, while not expected, then our liquidity needs may exceed availability under our amended Domestic Credit Agreement and we might need to secure additional sources of funds, which may or may not be available to us. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Moreover, if the borrowing base (as calculated pursuant to our outstanding second lien debt) falls below the principal amount of such second lien debt plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for such debt on the last day of any two consecutive quarters, it could trigger an obligation to repurchase or repay second lien debt in an amount equal to such deficiency.

 

No more use of the term “substantial doubt”. It might be helpful if the change from year-end to quarter-end was explained in more detail.

 

As always, your thoughts and comments are welcome!

Going Concern Reporting – The Gap in GAAP Versus GAAS- Part Two

By: George M. Wilson & Carol A. Stacey

 

In our last post, we looked at Sears Holdings’ disclosures about its going concern issues and saw that the company used the language “substantial doubt exists related to the Company’s ability to continue as a going concern” in the footnotes to their financial statements. We also saw that Sears Holdings’ auditors did not mention this issue in their report.

 

While this might seem like a bit of a disconnect, it turns out that there is a gap between the disclosure requirements for companies and the reporting requirements for auditors. (Actually, there are multiple gaps!)

 

This post reviews the GAAP requirements of ASU 2015-15, which became effective for companies for years ending after December 15, 2016.

 

In the third and last post of this series we will explore the auditor’s reporting requirements and the “gaps” between company requirements and auditor’s requirements.

 

Company Requirements

 

Here is a brief summary with some excerpts from the requirements for companies in ASC 205-40-50:

In connection with preparing financial statements for each annual and interim reporting period, an entity’s management shall evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable).

 

……………………………..

 

Management shall evaluate whether relevant conditions and events, considered in the aggregate, indicate that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued. The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued (for example, plans to raise capital, borrow money, restructure debt, or dispose of an asset that have been approved but that have not been fully implemented as of the date that the financial statements are issued).

 

……………………………..

 

When relevant conditions or events, considered in the aggregate, initially indicate that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (and therefore they raise substantial doubt about the entity’s ability to continue as a going concern), management shall evaluate whether its plans that are intended to mitigate those conditions and events, when implemented, will alleviate substantial doubt about the entity’s ability to continue as a going concern.

 

……………………………..

 

With this as the general requirement for an evaluation, the disclosure requirement comes with a binary determination about the impact of management’s plans:

 

Disclosures When Substantial Doubt Is Raised but Is Alleviated by Management’s Plans (Substantial Doubt Does Not Exist)

 

ASC 240-40-50-12

 

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is alleviated as a result of consideration of management’s plans, an entity shall disclose in the notes to financial statements information that enables users of the financial statements to understand all of the following (or refer to similar information disclosed elsewhere in the notes):

 

  1. Principal conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern (before consideration of management’s plans)
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that alleviated substantial doubt about the entity’s ability to continue as a going concern.

 

 

 

Disclosures When Substantial Doubt Is Raised and Is Not Alleviated (Substantial Doubt Exists)

 

ASC 240-40-50-13

 

If, after considering management’s plans, substantial doubt about an entity’s ability to continue as a going concern is not alleviated, the entity shall include a statement in the notes to financial statements indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Additionally, the entity shall disclose information that enables users of the financial statements to understand all of the following:

 

  1. Principal conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern
  2. Management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations
  3. Management’s plans that are intended to mitigate the conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern.

 

An interesting difference between these two levels of disclosure is that there is no requirement to use the terminology “substantial doubt” when management’s plans alleviate the uncertainty.

 

The language Sears Holdings used was:

 

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements.

 

 

The company used the term “substantial doubt” even though they believed their plans mitigated this “substantial doubt”. Their disclosure went beyond the requirements of the standard.

 

In our next post, we will explore how this interacts with GAAS for auditors.

 

As always, your thoughts and comments are welcome!

Going Concern Reporting – The Gap in GAAP Versus GAAS – Part One

By: George M. Wilson & Carol A. Stacey

 

This is the first of three posts about an interesting conundrum in reporting that arose last year. The FASB, with ASU 2014-15, now requires disclosures by companies about going concern issues. However, there can be gaps between what companies are required to disclose and impact of going concern issues on the auditor’s report.

ASU 2014-15 added subtopic 205-40 “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern” to the Accounting Standards Codification. This update became effective for periods ending after December 15, 2016. Previously there was no specific requirement for management to make these disclosures. (This is of course Generally Accepted Accounting Principles, or GAAP).

Auditors have had guidance in this area for many years courtesy of the PCAOB’s standard in AU section 341, which is now section AS 2415 in the PCAOB’s reorganized auditing standards. (This is Generally Accepted Auditing Standards, or GAAS).

 

To explore the gap between GAAP for companies and GAAS for auditors when reporting going concern issues we are going to present a series of three posts:

 

This first post will present an example of a going concern disclosure by a company and whether or not the auditor’s report was modified. (Spoiler – there was no mention in the auditor’s report!)

 

The second post will explore company disclosure requirements.

 

The third and last post will review auditor’s reporting requirements and detail the gaps between company and auditor reporting.

 

Sears Holdings, the retailer that owns Kmart and Sears, provided an example of this gap in their Form 10-K for the year ended January 28, 2017. In their financial statements Sears Holdings included this language:

We acknowledge that we continue to face a challenging competitive environment and while we continue to focus on our overall profitability, including managing expenses, we reported a loss in 2016 and were required to fund cash used in operating activities with cash from investing and financing activities. We expect that the actions taken in 2016 and early 2017 will enhance our liquidity and financial flexibility. In addition, as previously discussed, we expect to generate additional liquidity through the monetization of our real estate and additional debt financing actions. We expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs. We also continue to explore ways to unlock value across a range of assets, including exploring ways to maximize the value of our Home Services and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands through partnerships or other means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including our real estate portfolio, in our transition from an asset intensive, historically “store-only” based retailer to a more asset light, integrated membership-focused company.

 

Our historical operating results indicate substantial doubt exists related to the Company’s ability to continue as a going concern. We believe that the actions discussed above are probable of occurring and mitigating the substantial doubt raised by our historical operating results and satisfying our estimated liquidity needs 12 months from the issuance of the financial statements. However, we cannot predict, with certainty, the outcome of our actions to generate liquidity, including the availability of additional debt financing, or whether such actions would generate the expected liquidity as currently planned. In addition, the PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the planned actions take into account the applicable restrictions under the PPPFA.

 

If we continue to experience operating losses, and we are not able to generate additional liquidity through the mechanisms described above or through some combination of other actions, while not expected, we may not be able to access additional funds under our amended Domestic Credit Agreement and we might need to secure additional sources of funds, which may or may not be available to us. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Moreover, if the borrowing base (as calculated pursuant to the indenture) falls below the principal amount of the notes plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for the notes on the last day of any two consecutive quarters, it could trigger an obligation to repurchase notes in an amount equal to such deficiency.

 

Sears Holdings used the term “substantial doubt”, but indicated that they believed their plans mitigated this “substantial doubt”.

 

This was the report of Sear’s Auditors:

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sears Holdings Corporation and subsidiaries as of January 28, 2017 and January 30, 2016, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 28, 2017, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

No mention of a going concern issue at all in the auditor’s report! What is an investor to think? Historically, when the only concrete guidance was in GAAS, it was very rare to see this issue not discussed in both the financial statements and the auditor’s report.

 

This is, of course, part of the gap between GAAP and GAAS. In our next post we will begin to explore the space in this gap!

 

 

As always, your thoughts and comments are welcome!