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Going concern assumption

Going Concern Assumption

The going concern assumption is a fundamental principle in accounting principles that presumes a business entity will continue its operations for the foreseeable future. This means the entity has neither the intention nor the necessity to cease trading or undergo business liquidation in the immediate future, typically considered to be at least 12 months from the financial statements date. The going concern assumption underpins how assets and liabilities are valued and presented, largely justifying the use of historical cost accounting rather than liquidation values.

History and Origin

The concept of a "going concern" has roots dating back to the 17th century, with its earliest documented use traced to a 1620 lawsuit that distinguished between a going-concern value and a value akin to historical cost.23 Initially residing primarily within legal contexts concerning entity valuation, the idea gained prominence in accounting literature with Lawrence R. Dicksee's 1892 publication, Auditing: A Practical Manual for Auditors.22

Over time, this assumption became an integral part of established financial reporting frameworks worldwide. For instance, International Accounting Standard 1 (IAS 1), part of the International Financial Reporting Standards (IFRS), explicitly states that financial statements should be prepared on a going concern basis unless management intends to liquidate the entity or cease trading, or has no realistic alternative but to do so.21,20,19 In the United States, while universally accepted by accounting professionals, the going concern assumption was not formally incorporated into Generally Accepted Accounting Principles (GAAP) until the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-15, which became effective for annual periods ending after December 15, 2016.18,17 This update, codified as ASC 205-40, clarified management's responsibility to assess the entity's ability to continue as a going concern.16,15

Key Takeaways

  • The going concern assumption posits that a business will continue operating for the foreseeable future, usually at least 12 months.
  • It is a foundational principle for preparing financial statements, especially under the accrual accounting method.
  • This assumption dictates that assets and liabilities are recorded at historical cost rather than liquidation values.
  • Management is responsible for assessing the entity's ability to continue as a going concern and disclosing material uncertainties.
  • Auditors evaluate management's assessment and may modify their audit report if substantial doubt exists.

Formula and Calculation

The going concern assumption does not involve a specific formula or calculation. Instead, it is a qualitative assessment of a company's ability to remain in business for a specified period. Management's assessment often involves evaluating various financial and non-financial indicators, such as liquidity, solvency, recurring losses, negative cash flow analysis from operations, and dependence on a single customer or product. While there is no formula, the assessment process outlined by accounting standards like ASC 205-40 in U.S. GAAP involves specific steps:

  1. Evaluate conditions and events: Management assesses whether conditions and events, considered in aggregate, raise substantial doubt about the entity's ability to meet its obligations within one year after the date the financial statements are issued. This initial evaluation does not consider potential mitigating plans.14
  2. Consider management's plans: If substantial doubt is raised, management evaluates whether its plans intended to mitigate those conditions and events will alleviate that doubt. Plans must be probable of being effectively implemented and probable of mitigating the doubt.13,12

Interpreting the Going Concern Assumption

Interpreting the going concern assumption primarily involves understanding its implications for financial reporting. When financial statements are prepared under the going concern basis, it implies that the reported asset valuation and liability management are based on the expectation of ongoing operations. For example, the carrying value of a factory would be its depreciated cost, not its immediate resale value if the business were to shut down.

If there are significant doubts about a company's ability to continue as a going concern, management is required to disclose these uncertainties in the notes to the financial statements. This disclosure provides crucial information to users of the financial statements, such as investors and creditors, helping them assess the risks associated with the entity. Auditors also play a critical role, evaluating management's assessment and, if necessary, adding an explanatory paragraph to their audit report to highlight substantial doubt, even if alleviated by management's plans.11,10

Hypothetical Example

Consider "TechInnovate Inc.," a startup company that has been operating for two years. For its latest annual balance sheet, TechInnovate's management needs to assess its going concern status. They review the company's financial performance and projections.

  • Positive Indicators: TechInnovate has a promising new product in development, a strong management team, and a recent small angel investment.
  • Negative Indicators: Despite the product potential, the company has experienced recurring net losses shown on its income statement, has negative operating cash flow, and its current cash reserves are projected to last only six more months if no additional funding is secured. The company also has significant corporate debt coming due in five months.

Based on these negative indicators, management concludes there is substantial doubt about TechInnovate's ability to continue as a going concern for the next 12 months. They develop a plan to alleviate this doubt, which includes aggressively seeking a new round of venture capital funding and negotiating with existing creditors to restructure the debt. They have term sheets from potential investors that are considered probable of closing and initial positive discussions with lenders.

Because their plans are deemed probable of being effectively implemented and mitigating the doubt, TechInnovate's management can still prepare its financial statements on a going concern basis. However, they must include detailed disclosures in the notes to the financial statements explaining the conditions that initially raised substantial doubt and the mitigating plans.

Practical Applications

The going concern assumption is fundamental across various aspects of finance and business:

  • Financial Reporting: It is the bedrock upon which financial statements are prepared, influencing the classification of shareholders' equity and how assets and liabilities are measured. Without this assumption, companies would have to report assets at their liquidation value, which could dramatically alter the financial picture.
  • Auditing: Independent auditors are required to evaluate management's assessment of the going concern assumption. If they identify conditions or events that cast substantial doubt on a company's ability to continue as a going concern, they must consider the adequacy of management's disclosures and may issue a modified audit report.9,8 Research indicates that such audit modifications can signal financial distress to investors.7
  • Lending and Investment Decisions: Lenders and investors heavily rely on the going concern assumption when making decisions. A company unable to demonstrate its ability to continue as a going concern poses a higher risk, impacting interest rates on loans or investment valuations. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) provide guidance related to disclosure practices, including those around a company's ability to continue as a going concern.6,5
  • Regulatory Compliance: Accounting standards boards, such as the FASB and the International Accounting Standards Board (IASB), mandate how the going concern assessment should be performed and disclosed. For example, the FASB's ASC 205-40 outlines specific requirements for U.S. companies.4,3

Limitations and Criticisms

Despite its foundational role, the going concern assumption has limitations and has faced criticisms:

One primary criticism revolves around the subjective nature of management's assessment and the inherent forward-looking uncertainty. While standards like ASC 205-40 require management to consider conditions and events, the "probability" assessment of meeting obligations or the effectiveness of mitigating plans can involve significant judgment. This can lead to situations where a company's going concern status is disclosed, yet shortly thereafter, it faces severe financial distress or even bankruptcy, raising questions about the timeliness and predictive power of the assessment.2

Furthermore, the 12-month look-forward period mandated by many financial reporting standards might be too short to capture long-term solvency issues, potentially providing a limited view to stakeholders. Some critics argue that the assumption can inadvertently mask underlying financial fragilities if disclosures are not sufficiently robust or if management's plans are overly optimistic. Auditors, while tasked with evaluating management's assessment, are not guarantors of future viability.1

Going Concern Assumption vs. Liquidation Basis of Accounting

The going concern assumption stands in direct contrast to the liquidation basis of accounting. The going concern assumption presumes a business will continue operating indefinitely, justifying the recording of assets at their historical cost (less depreciation) and liabilities with the expectation of normal settlement in the future. Financial statements prepared under this assumption focus on the company's operational performance and financial position as an ongoing entity.

Conversely, the liquidation basis of accounting is applied when a business is no longer considered a going concern—meaning management intends to liquidate the entity, or liquidation is imminent. Under this basis, assets are revalued to their estimated net realizable value (what they would sell for in a forced sale), and liabilities are restated to the estimated amounts required to settle them. The focus shifts from profitability and ongoing operations to the orderly (or disorderly) winding down of the business, presenting a different picture of the company's financial state to reflect its impending cessation.

FAQs

What does "foreseeable future" mean in the context of going concern?

For accounting purposes, "foreseeable future" typically refers to a period of at least 12 months from the date the financial statements are issued. Management must assess the company's ability to meet its obligations within this timeframe.

Who is responsible for assessing going concern?

Company management is primarily responsible for assessing an entity's ability to continue as a going concern. External auditors then evaluate management's assessment as part of their audit report.

What happens if a company is not a going concern?

If a company is determined not to be a going concern, its financial statements must be prepared using the liquidation basis of accounting, rather than the standard going concern basis. This involves revaluing assets and liabilities to their estimated liquidation values.

Can an auditor issue an unqualified opinion even if there's substantial doubt about going concern?

Yes, an auditor can issue an unqualified opinion even if substantial doubt about going concern exists, provided that management's plans to mitigate the doubt are probable of being effectively implemented and the related disclosures in the financial statements are adequate. If substantial doubt is not alleviated, or disclosures are insufficient, the auditor would typically issue a modified opinion.

Is the going concern assumption the same across all accounting standards?

While the core concept is similar, the specific requirements for assessing and disclosing going concern uncertainties can vary slightly between different financial reporting standards, such as U.S. GAAP (ASC 205-40) and IFRS (IAS 1).