When a firm files for bankruptcy, someone loses a financial investment. Whether the filing is chapter 7 or chapter 11, creditors may get only a portion of a return (or none) of their investment, and investors may well lose their entire investment. However, filing for bankruptcy does not mean that a firm goes out of business.
For example, Bridgetech Holdings filed for chapter 11 on July 6, 2011, with zero assets on the balance sheet and $10 million of liabilities (all current). It had a $58 million total retained deficit on zero revenues over its existence. Bridgetech continued operations, eventually changing its name to Global Seafood Holdings, and on its Dec. 31, 2014, 10-K had $52 million[1] in retained deficit. Bridgetech still had earned no revenues but continued operations through private financing. Predicting bankruptcy is difficult, if the track record of certified public accountant (CPA) firms is an indicator:
Approximately [40-50 percent] of all companies filing for bankruptcy since [1988][2] failed to receive a going-concern paragraph in the audit opinion on their last financial statements prior to filing for bankruptcy.... Twelve of the 20 largest bankruptcy filings in U.S. history took place in 2001 and 2002.... All 12 companies received an unqualified opinion on their most recent financial statements filed prior to the bankruptcy filing.[3]
The CPA firm conducting the audit may be held financially accountable. According to the Public Company Accounting Oversight Board (PCAOB), “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.”[4] While the relevant accounting pronouncements do not define a “going concern,” there is some clarity on what is not a “going concern.” Auditors should consider that the entity is not a going concern if there is significant doubt about an entity’s ability “to meet its obligations as they come due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions.”[5]
In their decisions, auditors should consider management plans to address going-concern considerations. Auditors evaluate the mitigating effects of management plans in order to determine the potential effectiveness of those plans. Auditors must then conclude whether a going-concern paragraph in their audit report (GCAR) is necessary.
Following is Note 2 from Latitude Solutions’s 10-K for the year ending Dec. 31, 2011. Latitude Solutions’s management discussed, in general, its plans to address going-concern issues:
The Company currently has limited revenues and is incurring losses. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The Company is in the process of deploying its technologies and securing service contracts. Additionally, management plans to finance the Company’s operations through the issuance of debt and equity securities. However, management cannot provide any assurances that the Company will be successful in accomplishing its plan. The ability of the Company to continue as a going concern is dependent upon its ability to successfully accomplish the plan described in the preceding paragraph and eventually secure other sources of financing and attain profitable operations.
Apparently, the auditors, Mallah Furman, did not find Latitude Solutions’s management’s arguments compelling:
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the financial statements, the Company’s lack of revenue, continuing losses and dependence on outside financing raise substantial doubt about its ability to continue as a going concern.
A relatively new Accounting Standard Update (ASU) from the Financial Accounting Standards Board (FASB) will require firm management to also evaluate going-concern considerations and possibly issue a going-concern statement. FASB ASU 2014-15 requires firm management to:
evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date the financial statements are issued.[6]
The one-year time frame for auditors starts at the balance sheet date, but the one-year time frame for management starts when the financial statements are issued. Some nonpublic firms and their auditors wait until the one-year-from-financial-statement period has expired or is about to expire to issue the financial statements (to verify that the company is a going concern).[7]
The Data
New Generation Research provides selected financial data for companies filing for bankruptcy, including whether the corporation filed for chapter 7 or 11, and the filing date. Securities and Exchange Commission (SEC) filings (10-K, 10-Q) include financial data and auditors’ letters. The data set examined includes all 500 publicly traded companies filing for bankruptcy from Jan. 1, 2009, to Feb. 1, 2013. This study examined firms with a bankruptcy filing date within 1,000 days (and 365 days) of the year-end date of the last 10-K before bankruptcy filing. There were 405 such firms. Exhibit 1 (attached) provides a breakdown of CPA firms auditing the 405 firms examined in this study.
Firms filing for bankruptcy included some familiar names: Eastman Kodak, Sbarro, Harry and David, Borders Group, Blockbuster, Movie Gallery, CIT Group, Reader’s Digest Association, Lear Corp., Eddie Bauer, BearingPoint and BPI Energy Holdings. The largest firm to file for bankruptcy was CIT Group, with more than $80 billion in assets. CIT’s debt exceeded $72 billion. Many firms, like Borders Group, filed for bankruptcy shortly after fiscal year’s end. Its year’s end was on Jan. 29, 2011; its bankruptcy occurred on Feb. 26, 2011; and the 10-K was filed on April 29, 2011.
However, some companies like BearingPoint filed the 10-K considerably after filing for bankruptcy. Its year’s end was on Dec. 31, 2008; the bankruptcy occurred on Feb. 18, 2009; and the 10-K was filed on June 5, 2009.
There were 188 firms filing the 10-K within 365 days of year’s end and filing bankruptcy after filing the 10-K. Non-Big 4 CPA firms performed well in identifying going concerns, missing only 20 percent overall and identifying all chapter 7 firms with a going-concern statement in their audit report. Big 4 firms missed 43 percent overall and missed half of the chapter 7 firms.
Findings
Examination of the firms and their filings leads to the following conclusions about CPA firms and public firms filing bankruptcy:
The Big 4 CPA Firms
• audit larger firms. This is not surprising, given the nature of auditing and the need to have auditors in numerous locations with larger clients;
• are less likely to issue a GCAR than are smaller CPA firms. This may well be a function of the Big 4 auditing larger firms, or it could be that the Big 4 are less cautious than smaller CPA firms because the Big 4 will have less financial difficulty covering a loss (not predicting ultimate bankruptcy);
• audit firms that are more likely to file for chapter 11 rather than chapter 7, compared with non-Big 4 clients; and
• audit firms that file 10-K reports faster and file for bankruptcy faster than firms audited by non-Big 4 firms.
Publicly Traded Firms
Larger firms (1) are more likely to file for chapter 11 rather than chapter 7; (2) file their 10-K and file bankruptcy faster after year’s end; (3) are less likely to receive a GCAR than smaller firms in similar financial condition; and (4) are more likely to be audited by a Big 4 firm. Meanwhile, firms filing for chapter 7 (1) take longer to file for bankruptcy after year’s end and after filing the 10-K than firms filing chapter 11; (2) are more likely to receive a GCAR than firms filing for chapter 11 (as chapter 7 firms are overall in worse financial condition, this is an expected outcome); and (3) are less likely to be audited by a Big 4 firm than firms filing for chapter 11.
Stockholders and creditors generally fare better in chapter 11 than chapter 7. The longer a firm in distress takes to file its 10-K, the more likely it’s going to file for chapter 7 rather than chapter 11. The improved performance of non-Big 4 CPA firms compared with Big 4 CPA firms is most pronounced at predicting chapter 7 (the more distressing form of bankruptcy). Stockholders, creditors and analysts might be swayed by the presence of a Big 4 firm name on the audit letter. This study shows that financially distressed firms (with a looming bankruptcy) are less likely to get a GCAR from a Big 4 auditor, so analysts, investors and creditors might do well to pay stronger attention when a non-Big 4 firm issues a GCAR.
[1] The deficit decreased due to a “gain on debt.” Generally Accepted Accounting Principles (GAAP) requires disclosure of debt at market value. As a firm’s performance declines, the value of its debt declines also, resulting in a gain for the firm.
[2] With the 1988 enactment of SAS 59: The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, auditors were required to provide going-concern statements in their audit reports, when appropriate.
[3] Elizabeth K. Venuti, “The Going-Concern Assumption Revisited: Assessing a Company’s Future Viability,” The CPA Journal, 2012, at 40.
[4] PCAOB Regulation AU § 341.02.
[5] PCAOB, AU § 341, 1.
[6] Financial Accounting Standards Board, “Presentation of Financial Statements: Going Concern,” No. 2014-15, August 2014, at 2.
[7] Kristy Illuzzi, “New Challenges in a Delicate Process,” Journal of Accountancy, March 2015, at 29.