Fortfuehrungsprinzip

What Is the Going Concern Principle?

The Going Concern Principle is a fundamental accounting principle in financial reporting that assumes a business entity will continue to operate for the foreseeable future, generally considered to be at least 12 months from the date the financial statements are issued or available to be issued. This principle is a cornerstone of the accrual basis of accounting, allowing companies to prepare their financial statements on the assumption that they will not need to liquidate their assets in the near term to meet liabilities. Without the going concern principle, financial statements would need to be prepared using liquidation values, which could significantly alter the reported financial position and performance.

The going concern principle allows for the deferral of certain expenses, such as depreciation, over the useful life of an asset, as it anticipates the company's ability to utilize that asset over time. It is a critical assumption that underlies how a company's equity and overall financial health are presented to stakeholders.

History and Origin

The concept of a "going concern" has roots tracing back to the 17th century, where its earliest documented use appeared in a 1620 lawsuit that distinguished between a business's operational value and its immediate liquidation value.¹³ This idea, initially more prevalent in legal contexts related to entity valuation, began to solidify within accounting practices with the advent of double-entry bookkeeping during the Renaissance. This accounting method inherently recognized that businesses generally operate with an expectation of indefinite continuation.¹²

The formal recognition and integration of the going concern concept into accounting standards evolved significantly over time, reflecting changes in business practices and economic environments. By the late 19th and early 20th centuries, as capital markets developed, the principle became increasingly vital as investors sought assurance about the long-term viability of their investments. Regulatory bodies and professional accounting organizations later codified the assessment and disclosure requirements related to the going concern principle, solidifying its place as a cornerstone of modern financial reporting.

Key Takeaways

• The Going Concern Principle assumes a business will continue operating indefinitely, or at least for the next 12 months.
• It is a fundamental accounting principle that underpins the accrual basis of accounting and valuation of assets.
• Management is responsible for assessing the company's ability to continue as a going concern, identifying any material uncertainty or doubt.
• If substantial doubt exists, specific disclosures regarding the conditions, events, and management's mitigation plans are required in the financial statements.
• Auditors evaluate management's assessment and may issue a modified audit report if significant uncertainties remain or disclosures are inadequate.

Interpreting the Going Concern Principle

The Going Concern Principle is interpreted as a foundational assumption for the preparation of financial statements. When a company's management prepares financial statements under this assumption, it signals to users that the business is expected to meet its obligations as they come due and will not need to liquidate assets or cease operations in the foreseeable future. This allows for the use of the historical cost principle for assets and the systematic recognition of revenues and expenses over time, rather than immediate recognition based on liquidation values.

However, if conditions or events raise substantial doubt about a company's ability to continue as a going concern, management must disclose these uncertainties. The presence of such disclosures indicates that while the financial statements are still prepared on a going concern basis, there are significant risks to the entity's continued operation. This information is crucial for investors, creditors, and other stakeholders in evaluating the company's liquidity and solvency, and their ability to fulfill future commitments.

Hypothetical Example

Imagine "GreenTech Innovations Inc.," a startup developing sustainable energy solutions. For its December 31, 2024, financial statements, management assesses the company's ability to continue as a going concern.

Scenario 1: Healthy Going Concern
GreenTech Innovations has secured significant new funding rounds, consistently positive cash flow from its pilot projects, and a strong pipeline of contracts for the next 18 months. Based on these factors, management concludes there is no substantial doubt about its ability to continue operations. The financial statements are prepared in the normal course, valuing assets at historical cost and recognizing revenue as earned, consistent with the going concern principle.

Scenario 2: Going Concern with Substantial Doubt
Suppose GreenTech Innovations has experienced several unexpected project delays, cost overruns, and a key investor has pulled out, severely impacting its liquidity. The company is projected to run out of operating cash within six months if no new funding is secured. Management identifies these conditions as raising substantial doubt about the company's ability to continue as a going concern.

In this scenario, even though GreenTech is still operating, management would be required to include detailed disclosures in the notes to its financial statements. These disclosures would explain the conditions that raise substantial doubt (e.g., recurring losses, negative cash flows, impending debt maturities), management's evaluation of their significance, and any plans to mitigate the issues, such as seeking emergency financing or significantly cutting operational expenses. This allows users of the financial statements to understand the precarious financial position despite the continued application of the going concern principle.

Practical Applications

The Going Concern Principle is a cornerstone in several areas of finance and accounting:

• Financial Statement Preparation: Both Generally Accepted Accounting Principles (GAAP) in the U.S. and International Financial Reporting Standards (IFRS) mandate that financial statements be prepared under the going concern assumption unless management intends to liquidate or cease trading, or has no realistic alternative but to do so.¹¹,¹⁰ In the U.S., FASB Accounting Standards Codification (ASC) 205-40 outlines management's responsibility to evaluate the entity's ability to continue as a going concern for a period of one year after the financial statements are issued.⁹,⁸
• Auditing: Auditors are required to assess the appropriateness of management's use of the going concern assumption. International Standard on Auditing (ISA) 570, "Going Concern," provides guidance for auditors in evaluating whether there is material uncertainty about a company's ability to continue as a going concern.⁷ If substantial doubt exists and adequate disclosures are made, auditors may issue an unmodified opinion but include an "emphasis-of-matter" paragraph in their audit report to highlight the uncertainty.⁶
• Credit Analysis and Lending: Lenders heavily rely on the going concern assumption when evaluating a company's creditworthiness. A company's inability to maintain a going concern status can lead to loan defaults, difficulty in securing new financing, and higher interest rates due to increased perceived risk.⁵
• Investment Decisions: Investors use the going concern assessment to gauge the long-term viability and stability of a company. A company facing going concern issues often sees its stock price decline and may struggle to attract new capital.

Limitations and Criticisms

While essential, the Going Concern Principle faces certain limitations and criticisms:

• Subjectivity of "Foreseeable Future": The "foreseeable future" is typically defined as 12 months, but this period may not always capture longer-term risks that could impact a company's survival. Management's assessment often involves significant judgment, especially during periods of economic uncertainty.⁴
• Delayed Warnings: Critics argue that the going concern opinion often comes too late to provide effective warnings to investors about impending bankruptcy. Historically, a significant percentage of public company bankruptcies were not preceded by audit reports modified for going concern uncertainties, leading to calls for earlier and more proactive disclosures.³
• Management Bias: Management might have an inherent bias to maintain the going concern assumption, potentially downplaying risks or overstating the effectiveness of mitigation plans to avoid negative market reactions or debt covenant violations.² Auditors must scrutinize these plans rigorously.
• Impact on Auditor Liability: The shift under U.S. GAAP (ASC 205-40) placing the primary responsibility for the going concern assessment on management has also raised questions about auditor liability. Even with management disclosures, auditors can still be viewed as blameworthy if a company fails shortly after an unqualified opinion, especially if the auditor did not adequately challenge management's assessment or ensure sufficient disclosures.¹

Going Concern Principle vs. Liquidation Basis of Accounting

The Going Concern Principle and the Liquidation Basis of Accounting represent two fundamentally different assumptions for preparing financial statements, often causing confusion due to their opposing natures.

The Going Concern Principle assumes a business will continue its operations for the foreseeable future, enabling the use of historical cost for assets, the deferral of expenses like depreciation, and the classification of assets and liabilities into current and non-current categories. This approach reflects an ongoing business's operational reality and allows for systematic revenue recognition and expense matching.

Conversely, the Liquidation Basis of Accounting is used when a company's liquidation is imminent, meaning management intends to cease operations or has no realistic alternative but to do so. Under this basis, assets are reported at their estimated net realizable values (what they could be sold for immediately), and liabilities are presented at their estimated settlement amounts. All expenses become current, and the distinction between current and non-current items becomes irrelevant. The financial statements then reflect the company's net assets available for distribution to stakeholders, fundamentally different from an ongoing business's operational performance. The key distinction lies in the underlying assumption about the entity's future: continued operation versus imminent cessation.

FAQs

What does it mean if a company is no longer a "going concern"?

If a company is no longer considered a "going concern," it means there is substantial doubt about its ability to continue operating for at least the next 12 months. This could be due to factors like recurring losses, negative cash flow, loan defaults, or legal issues. When this happens, financial statements must disclose this fact and may need to be prepared on a liquidation basis of accounting, valuing assets at their current realizable value rather than their historical cost.

Who is responsible for assessing a company's going concern status?

Company management is primarily responsible for evaluating whether there are conditions and events that raise substantial doubt about the entity's ability to continue as a going concern. This assessment is typically performed for each annual and interim financial reporting period. Auditors then review management's assessment and the adequacy of related disclosures.

What kind of information indicates a going concern issue?

Several factors can indicate a potential going concern issue. These include persistent operating losses, negative cash flow, accumulated deficits, defaults on debt agreements, significant legal proceedings, loss of a major customer or supplier, or an inability to obtain necessary financing. Management considers both quantitative (e.g., financial ratios, forecasts) and qualitative (e.g., industry conditions, contractual obligations) information in its assessment.

Does a "going concern" disclosure mean the company will definitely fail?

No, a "going concern" disclosure does not mean the company will definitely fail or enter bankruptcy. It signifies that there is a material uncertainty about its ability to continue operating in the foreseeable future. The disclosure aims to alert users of the financial statements to these risks and management's plans to mitigate them. Many companies that issue such disclosures successfully navigate their challenges and continue operations.