What Is the Going Concern Principle?
The going concern principle is a fundamental accounting principle that assumes a business entity will continue to operate indefinitely, or at least for the foreseeable future, without the intention or necessity of liquidation. This assumption underpins the preparation of financial statements, allowing companies to value assets and liabilities based on their continued use and settlement in the normal course of business, rather than at their immediate sale or liquidation value. Without the going concern assumption, all assets would need to be valued at their liquidation basis, which could significantly alter a company's financial picture.
History and Origin
The concept of a business as a continuing entity has deep roots in commercial practice, predating formal accounting standards. While the precise origins are debated, the idea gained prominence as businesses became more complex and required long-term planning and investment. In modern financial reporting, the codification and emphasis on the going concern principle have evolved significantly. For instance, the Financial Accounting Standards Board (FASB) issued proposals to improve financial reporting of going concern uncertainties, ultimately leading to Accounting Standards Update (ASU) 2014-15, which provided guidance on management's responsibility to evaluate and disclose an entity's ability to continue as a going concern.4 This shift formalized management's role in assessing ongoing viability.
Key Takeaways
- The going concern principle is a foundational assumption in financial accounting, meaning a business is expected to continue operating for the foreseeable future.
- It influences how assets are valued (e.g., at historical cost rather than liquidation value) and how expenses are recognized over time.
- Management is responsible for assessing the company's ability to continue as a going concern, typically for at least one year after the financial statement date.
- If substantial doubt about a company's ability to continue as a going concern exists, specific disclosures are required in the financial statements.
- The principle is crucial for providing relevant and reliable information to investors, creditors, and other stakeholders.
Formula and Calculation
The going concern principle is a conceptual accounting assumption and does not involve a specific formula or calculation. Instead, it serves as the underlying premise for how various financial elements are measured and presented in a company's financial reporting. For example, under the going concern assumption, long-lived assets are depreciated over their useful lives, rather than being immediately expensed or revalued at their potential sale price. Similarly, prepaid expenses and deferred revenues are recognized over future periods, reflecting the expectation of continued operations. Therefore, this section does not present a mathematical formula.
Interpreting the Going Concern Principle
The interpretation of the going concern principle is crucial for understanding a company's financial health and the basis of its reported figures. When financial statements are prepared under the going concern assumption, it implies that the company has neither the intention nor the need to liquidate or materially curtail its operations. This allows for the use of accrual accounting, where revenues and expenses are recognized when earned or incurred, regardless of when cash changes hands.
If there are significant doubts about a company's ability to continue as a going concern, management must assess whether these conditions raise "substantial doubt" about its ability to meet obligations within one year after the financial statements are issued. If substantial doubt exists, even if management's plans alleviate it, specific disclosures are mandated. Such disclosures provide critical insights to users of financial statements regarding potential risks to the entity's continued operation.
Hypothetical Example
Consider "Horizon Innovations Inc.," a technology startup. For its annual financial statements, the management of Horizon Innovations asserts that the company is a going concern. This means they expect the company to continue its operations, develop its products, and meet its financial obligations for at least the next 12 months.
Based on this going concern assumption, Horizon Innovations' balance sheet reports its research and development equipment at its historical cost, depreciated over its estimated useful life. Its prepaid software licenses are recorded as assets to be expensed over the subscription period, and deferred revenue from long-term customer contracts is recognized over the service delivery term. If, however, Horizon Innovations was facing severe financial distress, such as running out of cash with no clear path to new funding, and management anticipated ceasing operations within the next few months, they would be required to prepare their financial statements on a liquidation basis. This would mean valuing assets at their estimated realizable value, which would likely be much lower than their historical cost, and treating liabilities as immediately due.
Practical Applications
The going concern principle has profound practical applications across financial analysis, auditing, and regulatory compliance. It serves as the foundation upon which many accounting standards are built, dictating how assets, liabilities, revenue, and expenses are recognized and measured. For investors and creditors, the explicit or implicit affirmation of a company's going concern status is a primary indicator of its long-term viability and ability to generate future cash flows, influencing investment decisions and lending terms.
Auditors play a crucial role in evaluating management's assessment of a company's ability to continue as a going concern. The Public Company Accounting Oversight Board (PCAOB) emphasizes that the auditor's evaluation of a company's ability to continue as a going concern is a vital part of an audit under PCAOB standards and federal securities law.3 This evaluation informs the auditor's opinion on the financial statements, and if substantial doubt exists that is not alleviated by management's plans, the auditor's report may include an explanatory paragraph highlighting this uncertainty. Furthermore, regulatory bodies, such as the Securities and Exchange Commission (SEC), mandate specific disclosures related to going concern uncertainties, ensuring transparency for the market.2
Limitations and Criticisms
Despite its foundational role, the going concern principle has certain limitations and has faced criticism. One primary concern is that it relies on a forward-looking assessment, which inherently involves judgment and estimation. While management is required to consider all known and reasonably knowable information, unforeseen events can rapidly change a company's prospects.
A significant criticism often arises when companies fail shortly after receiving an unqualified audit opinion that did not raise going concern issues. Such instances can lead to an "expectations gap," where stakeholders believe the audit should have provided an earlier warning. For example, auditors have been criticized when companies went bankrupt despite the auditor having given a clean opinion on the financial statements, with reports indicating that in a notable percentage of cases, companies deemed financially healthy for continuity still went bankrupt.1 This highlights the challenge of predicting future insolvency and the potential for the principle to mask underlying financial deterioration until it becomes critical. Additionally, the principle's reliance on historical cost accounting for asset valuation may not reflect true market values, particularly in a distressed scenario where impairment might be significant.
Going Concern Principle vs. Liquidation Basis
The going concern principle and the liquidation basis are two contrasting fundamental assumptions for preparing financial statements. The going concern principle assumes a business will continue its operations for the foreseeable future, enabling the recognition of assets at their historical cost (less depreciation/amortization) and the deferral of expenses and revenues. This approach reflects an ongoing operational entity.
In contrast, the liquidation basis of accounting is applied when a business is no longer considered a going concern—meaning its bankruptcy or cessation of operations is imminent. Under the liquidation basis, assets are valued at their estimated net realizable value (what they are expected to sell for), and liabilities are presented at the amount expected to be paid to settle them. This immediate revaluation provides a clearer picture of what creditors and equity holders might expect to recover if the company were to cease operations and sell off its assets. The key distinction lies in the fundamental premise: continued operation versus imminent cessation and asset disposal.
FAQs
What does "foreseeable future" mean in the context of the going concern principle?
The "foreseeable future" generally refers to a period of at least 12 months from the date the financial statements are issued or available to be issued. However, management must consider all relevant information known or reasonably knowable that extends beyond this 12-month period if it impacts the company's ability to meet its obligations.
Who is responsible for assessing a company's going concern status?
Company 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 review and assess management's determination as part of their audit procedures.
What are some "red flags" that might indicate a company is not a going concern?
Red flags can include recurring operating losses, negative cash flow from operations, working capital deficiencies, loan defaults, inability to obtain new financing, loss of key customers or suppliers, and significant legal proceedings. These indicators collectively suggest potential challenges to a company's solvency.
What happens if a company is no longer a going concern?
If a company is no longer a going concern, its financial statements must be prepared under the liquidation basis of accounting. This involves revaluing assets and liabilities based on their expected realization or settlement values, often leading to significant changes in the reported financial position and requiring extensive disclosures to inform stakeholders.