What Is Going Concern Value?
Going concern value refers to the implicit assumption in financial accounting that a business will continue operating indefinitely into the foreseeable future, rather than being liquidated. This foundational principle, central to the broader category of Financial Accounting, allows companies to present their assets and liabilities on a historical cost basis rather than at their immediate sale or liquidation value. Without the going concern assumption, financial statements would need to reflect a company's breakup value, which is often significantly lower than its operating value. Essentially, the going concern value reflects the enterprise's ability to utilize its resources and generate future economic benefits as an ongoing entity.
History and Origin
The concept of going concern has been an underlying principle in accounting for centuries, recognized implicitly in the practice of accrual accounting. Historically, the idea that a business would continue operating was simply assumed for financial reporting purposes, without explicit guidance on management's responsibility to assess it. This created a situation where external auditors were often primarily responsible for determining if a company could continue as a going concern, a role that sometimes put them in an uncomfortable position with clients.12
In the United States, specific authoritative guidance on management's assessment of going concern was lacking in Generally Accepted Accounting Principles (GAAP) for a long time. However, to clarify responsibilities and improve financial reporting, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 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." This update formally placed the responsibility on management to evaluate a company's ability to continue as a going concern for a period of one year after the date the financial statements are issued or available to be issued., Th11i10s significant development, effective for annual periods ending after December 15, 2016, ensures that management actively assesses and discloses any substantial doubt about the entity's ability to continue operations.
##9 Key Takeaways
- The going concern principle assumes a business will operate indefinitely, forming the basis for financial reporting and asset valuation.
- It distinguishes a company's operating value from its immediate liquidation value.
- Management is responsible for assessing the company's ability to continue as a going concern, typically for at least 12 months from the financial statement issuance date.
- If substantial doubt exists, specific disclosures are required in the financial statements to alert users.
- Auditors evaluate management's assessment and provide an opinion on the appropriateness of the going concern basis.
Interpreting the Going Concern Value
The interpretation of going concern value is less about a calculated numerical value and more about the fundamental premise underpinning a company's entire valuation. When a company is considered a going concern, it implies that its long-term assets, such as property, plant, and equipment, are valued at their cost (less depreciation) rather than their immediate sale price, and that deferred expenses and revenues are recognized over time. This approach reflects the expectation that the company will generate future cash flows and utilize its assets in ongoing operations.
Conversely, if there is "substantial doubt" about a company's ability to continue as a going concern, it signals significant financial distress. This determination often means that the company faces severe liquidity issues, recurring operating losses, negative equity, or other conditions that raise questions about its ability to meet its obligations as they become due. In such cases, financial statements may need to be prepared on a liquidation basis, which would significantly alter how assets and liabilities are presented, reflecting their estimated realization and settlement values, respectively.
Hypothetical Example
Consider "Tech Innovations Inc.," a startup company. For its annual financial statements, Tech Innovations Inc.'s management must assess if there is substantial doubt about its ability to continue as a going concern for the next 12 months.
- Initial Assessment: Management reviews the company's cash flow projections, current debt obligations, and revenue forecasts. They note that while the company has experienced initial losses common for startups, it has secured a new round of funding, has a strong pipeline of contracts, and its liquidity appears sufficient for the next 18 months based on reasonable assumptions.
- Conclusion: Based on this assessment, management concludes that there is no substantial doubt about Tech Innovations Inc.'s ability to continue as a going concern.
- Financial Reporting Impact: As a result, Tech Innovations Inc. prepares its financial statements assuming it will operate indefinitely. Its patents and developed software are recorded at their historical cost, and revenue from long-term contracts is recognized over the performance period, consistent with the accrual accounting principle. If management had concluded otherwise, they would have needed to disclose the uncertainties and potentially change the basis of accounting.
Practical Applications
The going concern principle is critical across various facets of finance and accounting. It is a fundamental assumption for preparing financial statements under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Without this assumption, the very structure and presentation of financial reports would be unworkable for most operating businesses.
Auditors play a crucial role in validating the going concern assumption. They are required to obtain sufficient evidence to conclude on the appropriateness of management's use of the going concern basis of accounting. This involves evaluating management's plans to mitigate adverse conditions and considering potential liquidity issues, such as declining revenues, increased interest costs on variable debt, or difficulties refinancing maturing debt., Th8e7 auditor's conclusion is reflected in their audit report, where an emphasis-of-matter paragraph may be added if substantial doubt exists, even if management's plans alleviate it.
Beyond financial reporting, the going concern principle influences investment analysis. Investors and creditors rely on this assumption when performing valuation analyses, such as discounted cash flow (DCF) models, which inherently project future cash flows for an ongoing entity. A company's ability to continue as a going concern directly impacts its creditworthiness and the terms on which it can obtain financing. For instance, in challenging economic environments, auditors and regulators increase scrutiny on going concern assessments, requiring companies to be transparent about their ability to meet obligations.
##6 Limitations and Criticisms
While essential, the going concern principle has limitations and faces criticisms. One significant challenge lies in the subjective nature of the "foreseeable future," typically defined as at least 12 months from the financial statement issuance date. Pre5dicting a company's solvency and operational viability accurately over this period, especially in volatile economic conditions, can be difficult. This inherent uncertainty means that even with a clean going concern assessment, unforeseen events can still lead to financial distress or bankruptcy.
Critics also point to instances where going concern opinions were issued without subsequent disclosures of significant doubt, only for the company to fail shortly thereafter. Such situations can lead to increased scrutiny from regulators and potential litigation for both management and auditors. The4 assessment requires significant judgment, and external factors like global economic crises can make it even more challenging for auditors to evaluate management's assertions. Des3pite guidance from bodies like the FASB, the forward-looking nature of the assessment means it relies on management's plans and assumptions, which may not always materialize as intended. As such, the going concern opinion is not a guarantee of future viability.
Going Concern Value vs. Liquidation Value
The distinction between going concern value and liquidation value is fundamental in finance. Going concern value, as discussed, presumes a business will continue its operations indefinitely, allowing its assets to be utilized and generate future income. Under this assumption, assets are typically carried at historical cost (less depreciation) on the balance sheet, and the overall value of the business reflects its earning power and operational synergy.
In contrast, liquidation value represents the net amount of cash that could be realized if a company's assets were sold off individually and its liabilities settled immediately. This valuation is applied when a business is expected to cease operations, sell its assets piecemeal, and distribute the proceeds to creditors and shareholders. Liquidation value is almost always significantly lower than going concern value because it does not account for the intangible value of an ongoing business, such as its brand reputation, customer relationships, skilled workforce, or the synergy between its various assets. Confusion can arise when a distressed company is valued; while its market value might fall below its book value, the specific accounting basis used for reporting changes significantly if the going concern assumption is abandoned in favor of a liquidation basis.
FAQs
What does it mean if a company is not a going concern?
If a company is determined to not be a going concern, it means there is substantial doubt about its ability to continue operating for at least the next 12 months. This finding signals that the business may face imminent bankruptcy or will be forced to liquidate its assets.
Who is responsible for assessing going concern?
Company management is primarily responsible for evaluating whether there is substantial doubt about the entity's ability to continue as a going concern. Ind2ependent auditors then review management's assessment and determine whether it is appropriate for the financial statements to be prepared on a going concern basis.
How often is the going concern assessment performed?
Under U.S. GAAP, management is required to perform a going concern assessment for each annual and interim reporting period. Thi1s ensures ongoing monitoring of a company's financial health and its ability to meet its obligations.
Does a going concern warning mean a company will fail?
No, a going concern warning or disclosure of substantial doubt does not guarantee that a company will fail. It is an early warning intended to alert users of the financial statements to potential risks and uncertainties. Management typically has plans to mitigate these issues, and the disclosure indicates that these plans are being evaluated or are in the process of being implemented.