Evaluating Going Concern in the era of COVID-19
The COVID-19 pandemic has created unprecedented uncertainty across the restaurant industry. Restaurants have experienced a significant disruption in consumer demand resulting in reduced operations, cash flows and liquidity concerns. As COVID-19 continues to evolve, restaurants will face challenges in evaluating their ability to continue as a going concern. This analysis will require Management to exercise significant judgment in evaluating existing conditions, future plans and forecasting funds necessary to maintain operations.
Accounting Standards Update 2014-15, Presentation of Financial Statements–Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern,
requires management to prepare an assessment of the Company’s presumed ability to continue as a going concern. Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at each reporting period. The evaluation of going concern applies to financial statements for each annual and interim reporting period.
Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probably that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or available to be issued).
Management should appropriately plan for the upcoming going concern analysis and talk to auditors early in the process. Management will need to provide auditors with the appropriate evidence and documentation to support their position, which may include a list of the key estimates, judgements, assumptions, and forecasts under multiple scenarios.
To prepare a going concern analysis, Management should consider the analysis in two steps: 1) assess the conditions and events that may indicate that it is probable that substantial doubt exists and 2) consider Management’s mitigating plans.
Under the first step, Management shall evaluate all relevant conditions and events, considered in the aggregate, that 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. This evaluation 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).
Management will need to consider both quantitative and qualitative information about various conditions and events, which may include:
- The entity’s current financial condition, including available liquidity sources, at the date that the financial statements are issued;
- The entity’s conditional and unconditional obligations due or anticipated within one year after the date that the financial statements;
- The funds necessary to maintain the entity’s operations considering its current financial condition, obligations and other expected cash flows for one year after the date that the financial statements are issued;
- Any other conditions or events that may adversely affect the entity for one year after the date that the financial statements are issued;
Examples of adverse conditions for restaurants may include:
- Negative financial trends, recurring operating losses;
- Working capital deficiencies, negative cash flows from operating activities;
- Restaurant closures;
- Default on loans, forecasted debt covenant violations, or the need to restructure debt to avoid default;
- Disruption in supply chain, or the loss of a significant supplier;
- Denial of trade credit from suppliers;
- Aging restaurants that need significant capital improvements to sustain operations;
- Legal proceedings that might jeopardize the entity’s ability to operate;
- Loss of a key franchisee(s) or license;
- Key locations with maturing leases without renewal options;
- Franchisee financial difficulties (inability to make royalty payments or need to obtain financing to sustain operations);
- Legislation or government mandated closures and limited capacity operations.
If initial substantial doubt is raised, Management then moves to Step 2 in the analysis.
Management considers all plans intended to mitigate those relevant conditions or events that, when implemented, alleviate the substantial doubt. Management’s plans are considered only to the extent that they meet both of the following criteria: (1) are probable that such plans will be effectively implemented within one year after the date that the financial statements are issued and (2) it is probable that the plans, when implemented, will mitigate the relevant conditions or events within one year after the financial statements are issued.
Possible mitigating factors to consider include, but are not limited to:
- Capital infusion from new and existing investors and debtors;
- Government assistance1 through enactment of the CARES Act which provides assistance such as loans under the Paycheck Protection Program (“PPP”) or deferral of employer FICA taxes;
- Modification of debt arrangements or availability of new debt financing;
- Modification or waiver of financial covenants;
- Cash infusion from sale leaseback transactions;
- Rent abatements and rent deferrals;
- Right-sizing store labor to account for decreased operating levels;
- Food cost reductions;
- Menu optimization and price increases;
- Negotiating better pricing with vendors;
- Payroll reductions through furloughs and temporary salary reductions;
- Postpone capital expenditure projects;
- Closing non-performing stores.
If initial substantial doubt is raised, it is first Management’s and then the auditor’s responsibility to evaluate whether Management’s plans, when implemented, mitigate the relevant conditions and events to alleviate the substantial doubt. The auditor must then determine if it is probable that the plan will be effectively implemented to mitigate the conditions or events that raised substantial doubt.
In the current economic environment, past history may not be appropriate to evaluate probability. Additional challenges include the dependence on third parties or the occurrence of events outside of management’s control. For example, such as when business will return to pre-COVID levels, the ability to access future financing or capital markets, renew leases, or obtain rent abatements. The preparation of multiple scenarios based on a variety of assumptions may be required to appropriately assess the probability of results in multiple market conditions. Management should also ensure that these assumptions are kept consistent with other analyses, such as projections and forecasts used for estimates, impairment, and income taxes.
If substantial doubt exists, it must be disclosed whether or not alleviated by Management’s plans. If substantial doubt is alleviated due to Management’s plans, the primary conditions and events that raised substantial doubt and Management’s plans that alleviated substantial doubt must be disclosed. If substantial doubt is not alleviated by Management’s plans, a statement in the disclosures indicating that there is substantial doubt must be disclosed and an emphasis-of-matter paragraph will be required in the audit or review report.
A going concern opinion with substantial doubt may trigger a debt covenant violation. It is best to have these discussions early with your bank to determine whether a debt covenant waiver is available.
Under the CARES Act many companies have received funds through the SBA in the form of a PPP loan. The additional debt and forgiveness of that debt may impact financial covenants. Under Accounting Standards Codification (“ASC”) 470, Debt
, the liability would only be derecognized upon repayment to the creditor or upon legal release under ASC 405-20, Extinguishments of Liabilities
. Legal release would only occur upon confirmation of forgiveness from the SBA. Additional information on the borrower’s accounting for PPP loans is available here
For more information on going concern for restaurants, contact Carrie Shagat
, National Restaurant Lead/Assurance Partner.
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1The Company’s eligibility for any governmental assistance would also be evaluated.