What Is Going Concern?
The going concern principle is a fundamental assumption in financial accounting that a business entity will continue to operate for the foreseeable future, generally considered to be at least one year from the date the financial statements are issued. This concept is a cornerstone of financial reporting, influencing how a company's assets and liabilities are valued and presented. If the going concern assumption is valid, a company's assets are typically valued at their historical cost, and liabilities are recorded as they become due in the ordinary course of business. Conversely, if there is substantial doubt about a company's ability to continue as a going concern, a different basis of accounting, often liquidation basis, might be required, which would significantly alter the valuation of its Asset and Liability.
History and Origin
The concept of going concern has long been an implicit understanding in accounting practices, recognizing that a business operates as an ongoing entity rather than one destined for immediate shutdown. However, its formalization and the explicit requirement for management and auditors to assess it evolved over time, particularly in response to financial crises and the need for greater transparency. In the United States, the Financial Accounting Standards Board (FASB) plays a crucial role in setting these standards. For instance, Accounting Standards Update (ASU) No. 2014-15, "Presentation of Financial Statements—Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern," formalized management's responsibility to evaluate and disclose conditions or events that raise substantial doubt about an entity's ability to continue as a going concern within one year after the financial statements are issued or available for issuance. T5his update shifted the primary responsibility for the going concern assessment from the Auditor to management, emphasizing that it is a core management responsibility to assess the ongoing viability of the reporting entity.
Key Takeaways
- The going concern principle assumes a business will continue operating indefinitely, or at least for the next 12 months.
- It influences how Financial Statements are prepared, particularly the valuation of assets and liabilities.
- Management is responsible for assessing a company's ability to continue as a going concern.
- If substantial doubt about going concern exists, specific disclosures are required in the financial statements.
- Failure to meet the going concern assumption often precedes events like Bankruptcy or Liquidation.
Interpreting the Going Concern
Interpreting the going concern assessment involves evaluating a company's financial health and operational viability. When a company's management or its auditor determines that there is "substantial doubt" about its ability to continue as a going concern, it signals significant financial distress. Substantial doubt typically exists if it is probable that the entity will be unable to meet its obligations as they become due within one year after the date the financial statements are issued. T4his assessment requires a comprehensive review of a company's financial condition, including its liquidity, profitability, and solvency, as well as qualitative factors such as current economic conditions and potential future events. If substantial doubt is identified, management must consider any plans to mitigate these conditions. If these plans do not alleviate the doubt, the financial statement footnotes must clearly state the substantial doubt and disclose the principal conditions, management's evaluation, and their mitigating plans. T3his transparency is crucial for investors and Creditors to make informed decisions.
Hypothetical Example
Consider "Alpha Tech Inc.," a hypothetical software company. For years, Alpha Tech has been profitable, and its financial statements have been prepared under the going concern assumption. However, in its latest reporting period, the company faced unforeseen challenges: a major product recall, significant litigation expenses, and a sudden drop in customer subscriptions.
Alpha Tech's management reviews its Cash Flow Statement and projections. They anticipate that without immediate action, the company will not have enough cash to cover its operating expenses and loan repayments over the next 12 months. This situation raises substantial doubt about Alpha Tech's ability to continue as a going concern.
To address this, management develops a plan: securing a new line of credit, implementing aggressive cost-cutting measures, and launching a new, highly anticipated product sooner than planned. They also plan to negotiate with existing Creditors for more favorable repayment terms. If, after considering these plans, management concludes that the substantial doubt is not alleviated, they would be required to include disclosures in Alpha Tech's financial statements outlining these conditions, their assessment, and the mitigating plans. If the plans are expected to alleviate the doubt, disclosures are still required, but less extensive.
Practical Applications
The going concern principle has broad practical applications across various financial disciplines. In Financial Reporting, it dictates the fundamental basis of accounting for most entities under Generally Accepted Accounting Principles (GAAP). For investors, an auditor's going concern modification or management's disclosure of substantial doubt acts as a critical red flag, indicating heightened risk and potential insolvency. This can significantly impact stock prices and investor confidence.
Regulators, such as the SEC, rely on going concern disclosures to monitor the financial health of public companies and ensure market transparency. Lenders and Creditors also scrutinize these assessments when making decisions about extending credit, as a company's ability to repay its debts is directly tied to its continued operation. Furthermore, the assessment of going concern has implications for corporate restructuring and Bankruptcy proceedings. The collapse of major financial institutions, such as Lehman Brothers in 2008, underscored the systemic importance of the going concern assessment. Lehman's bankruptcy, the largest in U.S. history, demonstrated how the failure of a major entity to remain a going concern could trigger a wider Economic Recession and significant market disruption., 2Global organizations like the International Monetary Fund (IMF) also monitor corporate vulnerabilities and potential default cycles, which are closely linked to the collective going concern status of businesses within an economy.
Limitations and Criticisms
While essential, the going concern principle has limitations. One criticism is its forward-looking nature, which inherently involves subjective judgment and estimates. Management's assessment of future cash flows and the effectiveness of mitigating plans can be optimistic, potentially masking underlying issues. Additionally, the "one-year look-forward period" may not be sufficient for identifying long-term solvency problems, particularly for companies in industries with long development cycles or significant capital expenditures.
Another challenge lies in the auditors' role. While management is primarily responsible, auditors must evaluate management's assessment. An auditor's report may include an "emphasis-of-matter" or "explanatory" paragraph regarding going concern uncertainties, even if management's plans alleviate the doubt. However, the timing of such disclosures can be crucial; a delay in recognizing or disclosing going concern issues can lead to a more severe outcome for Shareholders and creditors. For example, during periods of widespread financial stress, such as the 2008 financial crisis exacerbated by extensive exposure to Subprime Mortgages, many companies faced sudden and severe challenges to their going concern status, highlighting how quickly a seemingly stable entity can deteriorate.
Going Concern vs. Liquidation
The terms "going concern" and "Liquidation" represent two fundamentally opposing assumptions about a business entity.
| Feature | Going Concern | Liquidation |
|---|---|---|
| Assumption | The business will continue operating indefinitely or for the foreseeable future (at least 12 months). | The business will cease operations, and its assets will be sold off to pay Creditors. |
| Asset Valuation | Assets are recorded at their historical cost, net of depreciation, or fair value for certain items, assuming continued use. | Assets are valued at their estimated net realizable value (what they would sell for immediately). |
| Purpose | Basis for preparing standard Financial Statements (e.g., Balance Sheet, Income Statement). | Process of winding down a business, typically due to insolvency or unprofitability. |
| Outcome | Continued operations, ability to meet obligations in the normal course of business. | Dissolution of the company; proceeds distributed to creditors and then Shareholders. |
Confusion often arises because a company experiencing substantial doubt about its ability to continue as a going concern might ultimately end up in Liquidation. The going concern assessment is a proactive evaluation of viability, whereas liquidation is the ultimate consequence when that viability ceases to exist. Chapter 7 of the U.S. Bankruptcy Code, for instance, provides for "liquidation"—the sale of a debtor's nonexempt property and the distribution of proceeds to creditors. Thi1s legal framework is often invoked when a company's going concern is no longer viable, and reorganization under other chapters is not feasible.
FAQs
What does "going concern" mean in finance?
In finance, "going concern" refers to the assumption that a company will continue to operate and meet its financial obligations without the threat of Liquidation in the near future, typically for at least one year.
Who assesses a company's going concern?
A company's management is primarily responsible for assessing its ability to continue as a going concern. Independent Auditors then review and evaluate management's assessment when conducting an audit of the Financial Statements.
What happens if a company is not a going concern?
If a company is determined not to be a going concern, it means there is substantial doubt about its ability to continue operations. This often leads to disclosures in its financial statements, and in severe cases, can result in Bankruptcy or liquidation, where assets are sold to pay off Creditors.
Is there a formula to calculate going concern?
No, there isn't a single formula to calculate "going concern." Instead, it is a qualitative assessment based on a comprehensive review of a company's financial and operational factors, including its ability to generate sufficient cash flows, its current debt levels, and future business prospects.