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Going concern

What Is Going Concern?

Going concern is a fundamental accounting principle in financial reporting that presumes a business entity will continue to operate indefinitely, or at least for a foreseeable period, typically one year from the date the financial statements are issued. This assumption is critical because it underpins how assets are valued and liabilities are recognized. Under the going concern assumption, a company's assets are recorded at their historical cost less depreciation, and liabilities are classified as current or non-current based on when they are expected to be settled. Without the expectation of continued operations, a company would instead be valued on a liquidation basis of accounting, where assets are recorded at their estimated net realizable value, reflecting a scenario where the business ceases operations and sells off its assets. The ability to continue as a going concern is a key assessment made by both management and external auditors, as reflected in the auditor's report. The concept of going concern is central to understanding a company's financial health and future viability.

History and Origin

Historically, the concept of a "going concern" was an implicit assumption in financial reporting, primarily falling under the auditor's purview to identify and report on any significant doubts about a company's ability to continue operating. However, this changed significantly with the issuance of new accounting standards.

In August 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-15, "Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern" (codified as ASC 205-40). This update marked a pivotal shift by formally requiring management, rather than solely auditors, to evaluate whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern. The standard requires management to assess the entity's ability to meet its obligations for one year after the financial statements are issued or available to be issued. This new standard became effective for annual periods ending after December 15, 2016, and for interim periods within annual periods beginning after December 15, 2016.8 The FASB's decision to incorporate this guidance into accounting literature emphasized that the primary responsibility for assessing ongoing viability rests with an entity's management.7

Key Takeaways

  • The going concern assumption posits that a business will continue operating for the foreseeable future, typically at least one year from the financial statement date.
  • This assumption influences how assets are valued (historical cost) and liabilities are classified (current vs. non-current).
  • Both management and external auditors are responsible for evaluating a company's ability to continue as a going concern and disclosing any substantial doubts.
  • Indicators of going concern issues can include recurring operating losses, negative cash flows, or significant working capital deficiencies.
  • If substantial doubt exists, management must develop and assess plans to mitigate the adverse conditions, and appropriate disclosures are required in the financial statements.

Interpreting the Going Concern

Interpreting the going concern assessment involves evaluating a company's financial health and operational prospects to determine its ability to meet its obligations as they come due. A company operating under the going concern assumption is expected to realize its assets and discharge its liabilities in the normal course of business.

When management assesses going concern, they consider various factors, including current financial conditions, forecasted future cash flow statement, and the company's ability to access additional funding or restructure existing debt.6 The assessment aims to identify whether conditions or events, in aggregate, raise "substantial doubt" about the entity's ability to continue for the assessment period. "Substantial doubt" is defined as when it is probable that the entity will be unable to meet its obligations as they become due within one year after the financial statements are issued.5

For users of financial statements, a company's disclosure regarding going concern provides critical insight into potential risks. If substantial doubt is raised but alleviated by management's plans, the disclosures explain the conditions that caused the doubt and the plans implemented to overcome them. If substantial doubt is not alleviated, the disclosures must explicitly state this, along with the principal conditions, management's evaluation of their significance, and plans to mitigate them.4 Analysts and investors closely examine these disclosures to understand a company's liquidity and solvency and the potential impact on future operations.

Hypothetical Example

Consider "Horizon Innovations Inc.," a small tech startup that has been operating for three years. For its fiscal year ending December 31, 2024, Horizon's balance sheet shows significant accumulated losses, and its income statement indicates recurring negative operating cash flows. The company's current liabilities exceed its current assets, and a significant loan facility is due for repayment in July 2025. These conditions raise substantial doubt about Horizon Innovations Inc.'s ability to continue as a going concern beyond the next year.

Management, as required by accounting standards, performs an assessment. They identify the principal conditions: the recurring losses, negative cash flows, and the impending loan maturity. To alleviate this doubt, management develops a plan:

  1. Cost Reduction: Implement aggressive cost-cutting measures, including reducing discretionary spending and a limited hiring freeze, projected to save $500,000 annually.
  2. New Funding: Engage in discussions with venture capital firms to secure a new round of equity financing, targeting $2 million by April 2025.
  3. Revenue Growth: Launch a new, highly anticipated product feature in February 2025, with projections for significant revenue increase.

Management evaluates these plans and concludes that, taken together, it is probable they will be effectively implemented and will mitigate the conditions raising substantial doubt. Therefore, in their financial statements, Horizon Innovations Inc. would disclose the conditions that initially raised substantial doubt and the details of management's plans that alleviated that doubt. While no explicit statement of substantial doubt would be required if it's alleviated, the detailed disclosure provides transparency to users.

Practical Applications

The going concern assumption is fundamental across various facets of finance, impacting regulatory oversight, investment analysis, and business planning.

In auditing and financial reporting, the Public Company Accounting Oversight Board (PCAOB) provides specific guidance for auditors. For instance, 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 the entity's ability to continue as a going concern for a reasonable period, typically one year beyond the financial statement date.3 This involves scrutinizing management's assessment and the underlying evidence.

For investors and creditors, going concern disclosures are a crucial input for investment decisions and credit risk assessments. A "going concern opinion" from an auditor, indicating substantial doubt, often signals heightened risk and can significantly impact a company's stock price or its ability to obtain financing.

In corporate governance and strategic planning, the going concern evaluation forces management to regularly review the company's long-term viability. This proactive assessment often leads to strategic adjustments, such as seeking additional capital, divesting non-core assets, or re-evaluating business models, to ensure the company's continuity.

The going concern principle is a core element of both Generally Accepted Accounting Principles (GAAP) in the United States and International Financial Reporting Standards (IFRS) globally, underscoring its universal importance in ensuring reliable financial information.

Limitations and Criticisms

While the going concern assumption is fundamental, it faces certain limitations and criticisms, particularly regarding its forward-looking nature and the subjectivity involved in its assessment.

One key criticism relates to the inherent uncertainty in predicting future events. Auditors are not responsible for forecasting future conditions or events, and an absence of a reference to substantial doubt in an auditor's report does not assure an entity's ability to continue as a going concern indefinitely.2 The "one-year look-forward" period, while providing a defined timeframe, can be seen as arbitrary and potentially insufficient to capture longer-term viability issues.

Another limitation arises from the qualitative nature of many audit procedures involved in evaluating management's plans. While financial ratios and forecasts provide quantitative data, the assessment of whether management's plans will effectively mitigate substantial doubt often requires significant professional judgment.

High-profile corporate failures, such as that of Lehman Brothers in 2008, have brought the effectiveness of going concern assessments under scrutiny. Auditors faced criticism for their role leading up to the collapse, raising questions about whether sufficient warnings were provided.1 While auditors maintained their adherence to standards, such events highlight the challenges in identifying and disclosing risks with appropriate materiality in complex and rapidly evolving economic environments. The ongoing debate about auditor responsibility and the timing of disclosures in such cases underscores the complexities of the going concern assessment.

Going Concern vs. Liquidation Basis of Accounting

The concepts of "going concern" and "liquidation basis of accounting" represent two fundamentally different assumptions about a company's future and dictate distinct financial reporting methodologies.

Going Concern assumes that an entity will continue to operate for the foreseeable future, generally at least 12 months from the financial statement date. Under this assumption, assets are valued at their historical cost (or adjusted for depreciation/amortization), and liabilities are classified as current or non-current based on their expected settlement date in the ordinary course of business. This is the default assumption for most healthy businesses.

Conversely, the Liquidation Basis of Accounting is applied when an entity is no longer considered a going concern—meaning management intends to liquidate the entity, or it has no realistic alternative but to cease operations. When this basis is applied, financial statements are prepared with the objective of presenting assets at their estimated net realizable value (i.e., the amount expected to be received from their sale), and liabilities at their estimated settlement amounts. This approach reclassifies all assets and liabilities as non-current, reflecting the winding down of the business rather than ongoing operations. The key difference lies in the fundamental premise: continuation for going concern versus cessation for liquidation.

FAQs

Q1: Who is responsible for assessing a company's ability to continue as a going concern?
A1: Both a company's management and its independent auditors have responsibilities related to the going concern assessment. Management is primarily responsible for evaluating and disclosing uncertainties about the entity's ability to continue as a going concern in its financial statements. Auditors then evaluate management's assessment and determine whether appropriate disclosures have been made or if their auditor's report needs modification.

Q2: What happens if a company is no longer considered a going concern?
A2: If a company is determined to no longer be a going concern, meaning liquidation is imminent or unavoidable, its financial statements must be prepared under the liquidation basis of accounting. This changes how assets and liabilities are presented, valuing them at their estimated net realizable value rather than historical cost.

Q3: What types of conditions might raise substantial doubt about a company's going concern?
A3: Conditions that might raise substantial doubt include recurring operating losses, negative cash flows from operations, working capital deficiencies, defaults on loan agreements, significant legal proceedings, loss of a major customer, or loss of key personnel. Management must consider all such conditions in the aggregate when performing their Accounting Standards Update (ASU) assessment.