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What Is Going Concern?

Going concern is a fundamental assumption in financial reporting that a business entity will continue to operate indefinitely and will be able to realize its assets and discharge its liabilities in the normal course of business. This concept is a cornerstone of Generally Accepted Accounting Principles (GAAP) and influences how assets and liabilities are valued and presented on financial statements. Without the going concern assumption, a company's financial health would be viewed under the premise of imminent liquidation, leading to potentially drastic revaluations of its assets and obligations.

History and Origin

The going concern assumption has long been an implicit understanding in accounting, serving as the default basis for preparing a company's financial reports. Its formal articulation and the requirements for assessing and disclosing concerns have evolved significantly over time, particularly in response to major financial crises. Prior to 2014, the primary responsibility for evaluating and reporting on going concern issues typically rested with a company's independent auditor. For instance, the Public Company Accounting Oversight Board (PCAOB) Auditing Standard (AS) 2415, Consideration of an Entity's Ability to Continue as a Going Concern, outlines the auditor's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern for a reasonable period of time.³⁷

However, the financial crisis of 2008 highlighted a perceived gap in disclosure, particularly concerning early warnings about companies facing significant financial distress. Cases like Lehman Brothers spurred calls for enhanced transparency, as investors desired more proactive disclosure of potential financial health issues.³⁶ This led to the Financial Accounting Standards Board (FASB) issuing Accounting Standards Update (ASU) No. 2014-15, Presentation of Financial Statements—Going Concern, codified as ASC 205-40, in August 2014. T³⁵his update shifted the explicit responsibility for assessing going concern back to management, requiring them to formally evaluate and disclose substantial doubt about the entity's ability to continue as a going concern.

³⁴## Key Takeaways

• Going concern is a foundational accounting principle assuming a business will continue operating indefinitely.
• It impacts how assets and liabilities are valued and presented in financial statements.
• Management is responsible for assessing going concern, typically looking one year from the financial statement issuance date.
• Auditors also evaluate management's going concern assessment and may issue a modified auditor's report if substantial doubt remains.
• Failure to meet the going concern assumption may necessitate preparing financial statements on a liquidation basis of accounting.

Interpreting the Going Concern

The interpretation of a company's going concern status is critical for investors, creditors, and other stakeholders. When a company's management or auditor expresses substantial doubt about its ability to continue as a going concern, it signals significant financial distress. This assessment is not a precise calculation but rather a qualitative judgment based on various factors.

For management, the evaluation under FASB ASC 205-40 involves assessing whether conditions and events, considered in aggregate, raise substantial doubt about the entity's ability to meet its obligations as they become due within one year after the date the financial statements are issued. T³³hese conditions might include recurring operating losses, negative cash flow from operations, working capital deficiencies, defaults on debt covenants, or loss of major customers. If substantial doubt is identified, management must then consider its plans to mitigate these conditions, such as obtaining new financing, selling assets, or reducing costs.

³²For auditors, PCAOB AS 2415 requires them to evaluate management's assessment and determine if there is substantial doubt about the entity's ability to continue as a going concern. If such doubt exists, auditors consider the adequacy of disclosures in the financial statements and may include an explanatory paragraph in their auditor's report to highlight this concern. T³¹his provides users of the financial statements with a crucial warning regarding the company's viability.

Hypothetical Example

Consider "Alpha Tech Inc.," a startup experiencing rapid growth but also significant losses. In preparing its year-end financial statements, management observes that current liabilities exceed current assets (a working capital deficit) and that the company has consistently negative cash flow from operations. Furthermore, a key loan agreement includes a clause stating that if its liquidity ratio falls below a certain threshold, the loan becomes immediately due.

Based on these indicators, Alpha Tech's management identifies substantial doubt about its ability to continue as a going concern for the next 12 months. To address this, they develop a plan that includes securing a new line of credit, delaying non-essential capital expenditures, and negotiating revised payment terms with suppliers. If management determines that these plans are probable of alleviating the substantial doubt, they will disclose the conditions that initially raised the doubt, their evaluation of those conditions, and the plans put in place to mitigate them. If, however, the plans are not deemed probable of alleviating the doubt, the financial statements would include disclosures indicating the substantial doubt persists, alerting investors and creditors to the heightened risk assessment.

Practical Applications

The going concern principle has broad practical applications across various financial disciplines:

• Investment Analysis: Investors use going concern assessments to gauge a company's stability and long-term viability. A qualified auditor's report or management's disclosure of substantial doubt about going concern often leads to a re-evaluation of the company's stock value and its potential for bankruptcy.
• Lending and Credit Decisions: Lenders heavily rely on the going concern assumption. If there's doubt, it significantly increases the perceived risk of default, making it harder for the company to secure new loans or renew existing debt covenants.
• Mergers and Acquisitions (M&A): Acquirers scrutinize the going concern status of target companies. A target with going concern issues may command a lower valuation or require significant post-acquisition restructuring efforts.
• Regulatory Compliance: Regulatory bodies like the Securities and Exchange Commission (SEC) provide guidance on how publicly traded companies should address going concern issues in their financial statements and filings. The SEC's Financial Reporting Manual, for example, addresses the need for appropriate disclosures when there are going concern uncertainties.
  *³⁰ Legal and Litigation: In cases of corporate distress or failure, the timing and adequacy of going concern disclosures can become a central point in legal proceedings, particularly concerning potential auditor liability.

Limitations and Criticisms

While essential, the going concern assumption and its related reporting requirements face several limitations and criticisms:

• Timeliness of Disclosure: Critics argue that going concern warnings often come too late to be truly useful to investors. By the time a company's auditors or management disclose substantial doubt, the company may already be in severe distress, and its market capitalization may have significantly eroded. The case of Lehman Brothers, which failed shortly after issuing financial statements without a going concern qualification from its auditor, is frequently cited in this debate.
  *²⁹ Subjectivity of Assessment: The assessment of going concern involves significant management judgment and auditor professional skepticism. Determining whether plans to mitigate adverse conditions are "probable" of alleviating substantial doubt can be subjective, leading to inconsistencies in application.
• Self-Fulfilling Prophecy: The disclosure of going concern doubt, while intended to inform, can sometimes create a self-fulfilling prophecy. Customers, suppliers, and employees may lose confidence, exacerbating the company's financial difficulties. Lenders might withdraw credit, further imperiling the company's liquidity.
• Auditor Independence and Liability: Auditors face a challenging position. If they incorrectly issue an unqualified opinion on a company that subsequently fails, they can face significant legal and reputational repercussions. T²⁸his pressure can influence their assessment, potentially leading to Type II reporting errors, where going concern issues are not highlighted when they should be.

Going Concern vs. Liquidation Basis of Accounting

Going concern and the liquidation basis of accounting represent two fundamentally different assumptions about a company's future. The confusion often arises because the going concern assumption implicitly presumes the absence of liquidation.

Under the going concern assumption, assets like property, plant, and equipment are recorded at their historical cost and depreciated over their useful lives on the balance sheet, reflecting their use in ongoing operations. Revenues and expenses are recognized over time on the income statement, adhering to accrual accounting principles. In contrast, under the liquidation basis of accounting, assets are revalued to their estimated net realizable value, which is often significantly lower than their book value, reflecting a forced sale environment. Similarly, liabilities might be adjusted to reflect immediate settlement or additional costs associated with winding down operations. The shift to a liquidation basis indicates that the going concern assumption is no longer appropriate.

FAQs

Who is responsible for assessing going concern?

Under current accounting standards, a company's management is primarily responsible for evaluating whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern. Independent auditors then assess management's evaluation as part of their audit procedures and report.

What is "substantial doubt" in going concern?

"Substantial doubt" exists when conditions and events, considered in the aggregate, indicate that it is probable the entity will be unable to meet its obligations as they become due within one year after the date the financial statements are issued (or available to be issued).

What conditions might raise a going concern doubt?

Conditions that might raise a going concern doubt include recurring operating losses, negative cash flow from operations, significant working capital deficiencies, defaults on debt covenants, loss of a major customer or key supplier, significant litigation, or the inability to obtain necessary financing.

Does a going concern uncertainty mean the company will fail?

Not necessarily. A going concern uncertainty indicates that there is substantial doubt about the company's ability to continue operating, but it does not guarantee failure. Management typically develops plans to mitigate these conditions, and if these plans are successfully implemented, the company may overcome its difficulties. However, it serves as a critical warning sign for stakeholders.

What happens if a company cannot alleviate going concern doubt?

If a company cannot alleviate substantial doubt about its ability to continue as a going concern, its financial statements must disclose this fact, along with information about the conditions causing the doubt and management's plans (if any) to address them. The auditor's report would also typically include an explanatory paragraph highlighting this uncertainty. In extreme cases where liquidation is imminent, financial statements would be prepared on the liquidation basis of accounting rather than the going concern basis.^{1234567891011121314151617181920212223}