May 12, 2023
In the face of inflation, increased interest rates, multiple bank failures, and general economic uncertainty, many companies are experiencing difficulties with liquidity. Companies not only have to manage their liquidity during these challenging times carefully, but they also have to consider the financial reporting impacts and provide transparent disclosures. In addition, liquidity issues impact a company’s ability to continue as a going concern, which is an area of scrutiny by the auditors and investors.
Liquidity Considerations
Liquidity refers to having access to sufficient cash or other liquid assets to meet short-term obligations. A company’s liquidity is impacted by multiple factors, including cash flow management, the ability to obtain financing, economic disruption, and unplanned expenditures. As a result, companies need to manage their current cash and debt carefully and assess the availability of borrowings and other financing and their ability to raise additional capital.
Existing Cash and Debt
In light of the recent bank failures, companies should revisit where all their cash is located. If the bank amounts are not FDIC-insured, companies may be unable to recover their cash. Even if the amounts are FDIC-insured, companies may need more time to access their cash. As a result, companies should diversify their banking to reduce the risk if one bank fails.
Given the increasing interest rates, companies with variable-rate debt may want to restructure their existing debt. They may also consider increasing their revolver capacity to provide access to more cash in the short term. See our article on Accounting for Debt Modifications.
Availability and Access to Financing
Financing helps conserve cash flow. However, current circumstances may hinder a Company’s ability to close financing on terms suitable to the company or at all. Borrowing costs have increased due to higher interest rates. In addition, lenders may be less willing to issue new borrowing facilities or require more collateral or debt covenants to protect themselves.
Companies should also consider supplier finance programs. Supplier finance programs offer a flexible structure for paying for goods and services, enabling companies to keep more cash. In a supplier finance program, an intermediary or finance provider is involved. The finance provider pays the supplier, and the buyer pays the finance provider. Companies using supplier finance programs will need to disclose the details of the arrangement and business impacts in their financial statement footnotes.
Management of Working Capital
Companies should actively monitor their inventory, accounts receivable, and accounts payable to maximize cash flows. This includes making a greater collection effort to reduce Days Sales Outstanding, reducing inventory levels, maximizing Days Payable Outstanding to increase cash, or taking advantage of early payment discounts. Companies may also reallocate their investment portfolio to cash equivalents and short-term marketable securities to provide more flexibility and reduce risk.
Reduction/Management of Expenses
Many companies are restructuring their operations to reduce costs through reductions in force, office closures or consolidation, and termination of contracts. They may also defer capital expenditures or projects or eliminate them. These activities have a real impact on financials. See our article on Accounting for Exit and Disposal Costs.
Forecasting
When economic and business conditions are rapidly changing, forecasting reliably is made more difficult. Management needs to consider plausible downside scenarios and update the assumptions in the forecast as necessary. Management should also clearly explain all estimates and assumptions used in the forecast and have third-party support if available. Management’s forecast in the going concern assessment should be consistent with forecasts used in other financial statement areas. The forecast needs to be continuously monitored and updated. After updating the forecast, management will need to assess whether it expects to be able to meet its short-term obligations.
Credit Loss Considerations
Uncertain economic times and increased inflation and interest rates create more impairment risk for companies. Companies should evaluate their assets measured at amortized cost to see if the credit loss allowance needs to be updated. For example, customers may have more difficulty paying their invoices. As a result, companies must factor this in when they calculate their allowance for credit losses.
Also, what happens when the federal government can’t raise the debt ceiling and pay its debt obligations? This is a very real current concern. Although Congress has historically raised the debt ceiling, there are concerns that this time may differ. Even if they raise the debt limit, this can potentially impact those holding treasury bills or government securities at amortized cost since they are subject to the CECL model under ASC 326. Many companies may currently use the zero-loss exception for these securities, as they are issued by a sovereign government, which can print its currency, and whose currency is used worldwide as a reserve currency. While these are all still true, this may put more pressure on the zero-loss exception.
Going Concern
In accordance with ASU 2014-15, Presentation of Financial Statements – Going Concern (Subtopic 205-40), companies must assess going concern as part of their financial statements on an annual and interim basis. If the Company cannot pay its obligations and continue as a going concern twelve months from the issuance date of the financials, a going concern warning is issued by the company’s management and auditors.
First, the Company needs to analyze whether there are conditions that raise substantial doubt about the Company’s ability to continue as a going concern. This analysis looks at historical losses and operating cash flows, current financial conditions, including immediate sources of cash and commitments over the next 12 months, and an assessment of funds necessary to maintain the entity’s operations. If substantial doubt exists, the Company must assess management’s plan to alleviate the substantial doubt.
Management typically prepares a cash flow forecast, or at least an operating income/loss forecast, to determine whether it will be in a positive or negative cash position twelve months from the expected issuance date. Auditors are required to probe management’s forecast and question the assumptions used for revenue and expenses.
If the evidence points to substantial doubt, management needs to provide the auditors with their plans to mitigate the causes of the substantial doubt and the probability of effectively implementing those plans. The auditors would then conclude whether substantial doubt still exists and add language to their opinion if needed.
Management must also disclose its own assessment of whether substantial doubt exists and how it plans to alleviate it. If its plans do not resolve the substantial doubt, it must provide a going concern warning.
Disclosures
Due to the current economic uncertainties, it is important that companies disclose sufficient information to allow users to understand a company’s specific liquidity risks and ability to continue as a going concern on a timely basis. There should also be sufficient disclosure about a company’s financial risk management policies and programs. Many companies have disclosed risk factors around the recent bank failures and economic climate. Companies should also disclose any risks or uncertainties that could impact their financial statements in the short term.
