One of the most difficult discussions between an audit firm and a client’s management team is often whether or not substantial doubt exists about the entity’s ability to be a “going concern.” In other words, will the company continue operating/meeting its obligations within one year after financial statements are issued? Historically there has been a disconnect on this topic, since for years businesses were not required to assess the going concern of their entity.
That changed in 2014 when FASB issued Accounting Standards Codification (ASC) 2014-15, Presentation of Financial Statements - Going Concern (subtopic 205-40). This standard requires management to assess whether the financial condition of their company raises substantial doubt about its ability to continue operations within one year after the release of the financial statements. If there are concerns that go unmitigated, additional disclosures will be added to the final financial statements, which is not ideal for any company.
So, what should your management team focus on when it comes to evaluating your real estate entity’s ability to operate into the future? There are seven key areas to address, some of which are obvious, while others need to be considered together to illustrate how they may impact the going concern of your property. Below provides an overview of these important areas to analyze with your management team during your next audit.
Tenant move-outs can impact future cash flows — whether it’s one significant tenant who takes up five floors in the building, or several smaller tenants that make up a substantial portion of the property’s square footage. Management must evaluate any move-outs to determine how those tenant changes will impact future operations. Even if the property has positive cash flow in the year under audit, a major tenant or tenants that move out close to year-end in the period prior to the release of the financial statements, or an expected move-out within a year, can impact operating cash flow.
As part of this evaluation, management also should consider the possibility of any large tenant move-ins during the period subsequent to year-end. Hopefully, tenant move-ins will exceed the number of move-outs with consistent or better lease terms. Move-ins should be evaluated based on executed leases or expected new leases in final phases of negotiation, not potential new tenants who have merely visited the property. Management estimating a new lease will be executed in the next year that will take up a large majority of the property’s vacant space should be accurate based on prior history of tenant activity and impact of the local economic conditions. This needs to be a realistic assessment, not an aspiration of a better outlook for the property.
Tenant insolvency or bankruptcy issues leading up to the release of the financial statements will have an impact on the property’s cash flow. Again, management needs to evaluate whether the potential rejection of a lease for a bankrupt tenant, or rent concessions or significant outstanding rent payments for a tenant having financial difficulties, will negatively impact future cash flow. If it is impacted, management will need to evaluate the situation and identify alternative strategies to make up the short fall in rent.
If a property has had consecutive years of operating losses, whether due to declines in rent or, just as impactful, significant increases in operating expenses such as property taxes or interest expense, management needs to have a strategy to explain how the property will improve future cash flows. One year of operating losses can often be explained away as an anomaly, if there are no other factors involved; but, if there have been a few years of negative cash flow, then management must have a conclusive plan to justify the mitigation of the going concern issue.
One remedy to eliminate any going concern impact related to recurring operating losses would be for key investors, usually institutional in nature, to execute a representation letter. This letter expresses intent to fund future operating losses via equity contributions through a year and one day after the release of the financial statements.
When a mortgage is coming due in the next year or so, management must have a plan documenting how the debt will be refinanced or extended. In our current environment, this will be a real issue for many real estate ventures in the near future. Global investment and advisory financial services firm Guggenheim reports that nearly $1.2 trillion in commercial real estate debt will mature in 2024 and 2025 (“Commercial Real Estate – When Maturity Means Default”).
With the changing landscape of hybrid work environments and remote working arrangements in the office sector, lenders and institutional debt investors are reevaluating their portfolios and making new loan financing even more difficult to obtain. This impacts debt maturity significantly and hinders management’s strategies to get out of a going concern issue.
The maturity of fixed rate mortgages potentially present an additional issue. Since interest rates have been increasing over the last few years, a new loan will likely have significantly higher interest rates than those a few years back, negatively impacting cash flow in the future.
Loan defaults of any kind — whether for failing to make timely payments or a payment altogether, or the entity has a loan covenant failure — means your management team will need to evaluate whether a going concern issue now exists. You will need to analyze what type of default and its significance as well. For example, failing to file a particular report required in the loan documents might be considered minor compared to not meeting one of the prescribed debt service ratios listed in the loan agreement. Failing to make loan payments almost always results in a going concern issue.
Local market condition is a little more of an esoteric item related to going concern. Market condition is often very difficult to quantify and extrapolate to property operations; however, there are situations where it’s been applied in the past and so could be considered for future events. Examples include the impact of hurricanes or large wildfires devastating entire areas surrounding a property, or even the impact of our current office environment in which many tenants are reducing their footprint throughout the country. It’s important for management to address the market impact and articulate to auditors how their findings factored into their going concern assessment.
Delays and cost overruns, in either a new development or a significant construction project at the property, are other important areas to assess regarding overall going concern of the business.
Delays or overruns can occur due to shortages of material, labor strikes, failure to timely obtain the appropriate local permits or entitlements, project mismanagement or change in the scope of the project. Management must understand the delay or overrun and incorporate the possible financial impact to the property in their evaluation of whether a going concern issue exists. Postponements in construction are very difficult to assess as to the impact to the project, but your team should attempt to make a rational consideration to incorporate into your going concern assessment.
Management is, and needs to be, integrally involved in assessing whether or not substantial going concern items have been resolved to alleviate the need for any additional disclosures in the final financial statements. The possible addition of a going concern paragraph in the audit opinion is still not an easy conversation — for you or your auditors — but having management involved in the process from the beginning can help alleviate some of the stresses of the past.
Contact Nick Antonopoulos or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.