Over the next couple of years, "substantial doubt" and "going concern" will be the biggest issues in litigation involving CPA firms. If the patient approaches death, the doctor should not issue assurances of survival. If the corporation nears death, the annual report should not wait for rigor mortis to warn of impending disaster. During 2008, dozens of companies ceased to be going concerns shortly after issuing annual reports with little hint of looming doom.

Since 1988 there has been a requirement that, if there were "substantial doubt" about "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," there had to be a footnote to the financial statements and an extra paragraph in the audit opinion referring to that footnote and using the wording "substantial doubt." (AU 341 of the American Institute of CPAs' publication U.S. Auditing Standards. AU 341 is part of the interim standards of the Public Company Accounting Oversight Board.)

None of the annual reports discussed here has the footnote or extra paragraph.

Enron's report for the year ending Dec. 31, 2000, did not have the "substantial doubt" footnote and Arthur Andersen's report did not have the extra paragraph. Enron sought shelter from the bankruptcy court in December 2001, and Arthur Andersen died the following year. The issue, while not new, has never posed the challenge to the profession that follows from the vast number of companies that ceased to be going concerns in 2008.

To make the issues concrete, consider the 2007 annual reports of two companies: Washington Mutual and General Motors. Both had calendar years, both were audited by the same prestigious CPA firm, neither had the substantial doubt footnote, neither audit report dated Feb. 28, 2008, had the extra paragraph, and neither is a going concern today - but the two differ diametrically.


This large financial institution had income (loss) in the millions in its last three years, as follows:

2005 - $3,432;

2006 - $3,558; and,

2007 - $(67).

Certainly the loss in 2007 is important, but it is not large compared to revenues of $19.5 billion and compared to stockholders' equity at the beginning and end of the year of $26.97 billion and $24.6 billion, respectively.

Net cash flow from company operations, in millions, follows:

2005 - $1,789;

2006 - $7,269; and,

2007 - $7,697.

The financial statements do not hint at imminent demise.

By the end of 2007, it was apparent that 70 years of easy money had contributed to a housing "bubble" and that there were serious problems relating to sub-prime mortgages, but it would have been difficult to infer from the financial statements that these might overwhelm Washington Mutual in the next several months. The sober language in management's discussion and analysis and in the CEO's letter (part of which is repeated on the cover of the annual report) provides a better warning than would have been provided by a footnote toward the end of the report.

The CEO's letter said: "2007 can be characterized as a year of responding to change. 2008 will be an even more challenging period as we expect to feel the effects of very weak housing conditions and extraordinarily high loan loss provisioning."

While conditions in the financial industry were certainly serious by the date of the audit report, it would have been difficult for a CPA taking the vital signs to know that the patient would be dead by October.

Similar remarks apply to dozens of other financial institutions that met a similar fate in 2008. If the institutions had substantial stockholders' equity, if they met the capital requirements and various ratios required of financial institutions, it is difficult to hold the CPA responsible for not requiring the extra footnote and not writing the extra paragraph. Both the Federal Reserve and the Treasury Department were issuing statements in early 2008 about the ability of the financial industry to weather the storm; should we expect more of the CPA?


General Motors differs. The auditing standard (AU 341.06) suggests a number of "conditions and events" that could indicate "substantial doubt." One such condition is "negative trends" such as "recurring operating losses ... [and] adverse key financial ratios." The operating losses of GM, in millions, were:

2005 - $17,229;

2006 - $5,658; and,

2007 - $6,253.

No need for parentheses, as these are all losses. The net losses (the bottom lines) were:

2005 - $10,417;

2006 - $1,978; and,

2007 - $38,732.

In the category of "key financial ratios," consider the negative net worth and the ratio of liabilities to assets from the December 31 balance sheets:

2005 - $14,442 97%.

2006 - $(5,652) 103%; and,

2007 - $(37,094) 125%.

Among other indicators that there could be substantial doubt is the "need ... to dispose of substantial assets" (AU 314.06). GM's history for 20 years has been a history of disposing of substantial assets, which includes the disposition of its Hughes Division, its EDS Division and its wholly owned Delphi parts supplier. Many of these dispositions were doubtless motivated by a desire to concentrate on "core" automotive operations, but recent distributions - Delphi (1999); a 51 percent stake in General Motors Acceptance Corp. (November 2006); most of its Allison transmission operations (August 2007) - relate to these "core" operations and possibly reflect GM's desperation for cash. All these factors suggest - actually shout - "substantial doubt!"

The events following the 2007 annual report are sobering. The lobbying and cultivating of congressional relationships had been going on while the audit was being performed. By summer 2008, GM and its lobbyists were saying that GM was not a going concern and would not survive without an immediate infusion of federal cash. By late December, GM had received Troubled Asset Relief Program funds, thus denying its auditors an "out" based on the one-year provision of AU 341. The recently enacted stimulus package grants GM many billions of additional favors, although some of these are hard to quantify. The issue is no longer "substantial doubt;" GM is not a going concern.

And now comes the 2008 annual report of GM. This report states that the problems enumerated above "raise substantial doubt about its ability to continue as a going concern."

As one with great respect for GM's auditor, I would hope there are two things in the audit documentation for 2007. First, the documentation should indicate what additional procedures the auditor applied to overcome the internal control problem. Management's reports on internal control in the 2006 and 2007 (and also 2008) annual reports cite "material weaknesses" in internal control over "financial reporting" and conclude internal control "was not effective." The auditor's opinion on internal control agrees that, "The Corporation has not maintained effective internal control over financial reporting" and characterizes this as an "adverse opinion." The internal control opinion assures the reader that these "material weaknesses were considered in determining the ... audit tests applied" and that the internal control "report does not affect" the unqualified report given on the financial statements.

Hopefully the audit documentation has features that distinguish it clearly from the documentation for the 2004 GM audit, which cited no comparable problems with internal control and with the documentation for other audits without adverse opinions on internal control.

Second, let us hope that the audit documentation reveals what "mitigating circumstances" made it possible for the CPA firm to overcome the factors suggesting "substantial doubt."

Lacking these, there may be substantial doubt of a prominent CPA firm's ability to continue as a going concern.

John Coughlan, CPA, Ph.D, is president of the CPA School of Washington Inc., a Fairfax, Va.-based educator that offers accounting and financial curricula, including CPA and CMA Exam preparation.

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