by Michael Gallaher, Audit Associate at Sensiba San Filippo
To outside investors, the future of early stage and startup companies can be murky. Many of these companies are pre-revenue and in the cash burn stage as they try to establish their technology and market. When investors believe in the founders, products, or ideas they will provide companies with funding. However, as a condition of financing they may require annual audited financial statements.
During the audit process, the company needs to address the risk that it may not be able to continue as a “going concern.” Specifically, the audit team assesses the management’s conclusion as to whether or not the company can continue to operate while meeting its financial obligations.
No entrepreneur wants to think that their business won’t last, but as they burn cash in the developing years they need to consider future implications — particularly funding. Many of these companies operate at a loss with a negative cash flow, which begs the going concern question.
Here are a few things to understand about assessing going concern.
Changes in Going Concern Rules.
Due to new accounting standards effective for December 2016 year-ends, the future timeline that management must consider for cash flow needs has expanded to one year from the issuance date of the audited financials. That is up from previous standards which required an analysis of only one year from the date of the financial statements. This means that if a company gets its audited financial statements issued in July for the year ended the previous December, it tacks on seven more months to the going concern consideration. Therefore, management’s analysis needs to encompass a larger set of data. Management may wonder where to get a crystal ball to predict the future, but there are tools available that give good indications of what may happen.
What Management Should Consider.
Since auditors need to evaluate the justifications behind management’s going concern assertion, management can’t simply say that it believes that the company has no going concern issues. First and foremost, if cash on hand is greater than the anticipated cash burn, this probably alleviates this concern. If there is insufficient cash, then the company should have a plan to obtain sufficient capital. For many startups this results in a need to raise additional financing through debt or equity arrangements. Obtaining term sheets, note agreements, or even emails from lead investors stating their intentions to continue funding the entity may help support management’s assertion that they can raise more capital.
Company growth and future forecasts are a critical component of going concern analysis. The company’s cash flow forecast will have to be reasonably prepared and have solid business reasons supporting the inputs in order to win over skeptical auditors.
The key language in the accounting standard to consider is management’s need to assess whether substantial doubt exists about the company’s ability to continue as a going concern and whether it is probable that management’s plans to address this doubt will alleviate this concern. The conclusion is the responsibility of management, but the auditors must be provided with support for management’s position. What are the company’s obligations? Whether it is debt financing or a five year lease on a building, these commitments for use of the company’s cash play an integral part in the analysis.
Ultimately, this risk is a challenge that many startups face when in the cash burn mode, and the rules are significantly more stringent in the current year. Companies should be prepared for additional scrutiny and requests to provide supporting documentation to auditors. Solid forecast plans should also be backed up with sufficient support about the company’s ability to continue as a “going concern.”
Effect on the Financial Statements and the Company.
If the going concern is alleviated, the consideration is disclosed in the footnotes of the financial statements and nothing else is affected. However, if the going concern is not alleviated, the reasoning is disclosed in the footnotes and an additional paragraph explaining the going concern is added to the auditors’ report. Neither changes the opinion that would otherwise be expressed.
Many startups and early-stage companies fear that having a going concern paints their company in a negative light, which may therefore turn off potential investors. However, most investors funding these types of companies understand that they are in the business of utilizing cash to develop their products and are not worried about whether or not they have a going concern disclosure.
Michael Gallaher is an experienced Audit Associate at Sensiba San Filippo specializing in venture capital funds and venture backed startups in the San Francisco Bay Area. You can reach Michael at 650.358.9000 or at firstname.lastname@example.org.