Evaluating a company's ability to continue operations is an important but complex process.
This article will clearly define the accounting concept of "going concern" and provide guidance on assessing risks and uncertainties.
You'll learn the meaning of going concern, its role in financial reporting, key factors auditors evaluate, and strategies managers can employ to mitigate substantial doubt about an organization's ability to sustain operations.
Understanding Going Concern in Accounting and Financial Statements
The going concern concept refers to a company's ability to continue operating and meet its financial obligations for the foreseeable future, usually defined as at least 12 months. This introductory section will define going concern, explain its relevance for financial reporting, and outline key factors auditors consider when assessing an entity's ability to continue as a going concern.
What Is the Going Concern Assumption in Accounting?
The going concern assumption is a fundamental principle in accounting that assumes a company will remain in business for the foreseeable future, which is generally considered to be at least one year from the date of the financial statements. This allows a company to value its assets based on their long-term use within the business rather than liquidation value.
Some key points about the going concern assumption:
- It underlies the way financial statements are prepared. Assets reflect long-term use, liabilities assume repayment over time.
- Without this assumption, financial reporting would be significantly different and focused on breakup/liquidation values.
- Companies are required to make a "going concern assessment" when preparing financial statements. They analyze their ability to meet obligations over the next 12 months.
- If substantial doubt exists about an entity's ability to continue business, the financial statements must include disclosures about this uncertainty.
The going concern assumption provides the foundation for companies to present financial information on an operating basis rather than liquidation basis. It is a critical concept underlying accounting standards and financial reporting.
The Importance of Going Concern in Financial Statements
The going concern assessment has major implications for financial reporting and analysis:
- Asset valuation - With going concern, assets are recorded at historical cost and depreciated over useful lives. Without it, assets may need write-downs to liquidation values.
- Liability repayment - With going concern, liabilities are recorded at face value assuming contractual repayment over time. Otherwise, liabilities require adjustment for compromise/distressed settlements.
- Revenue recognition - Under going concern, revenues can be recognized over contract terms as performance obligations are satisfied. Without it, revenue may only be recognized as amounts become nonrefundable.
- Expenses - Going concern allows capitalization of costs expected to benefit future periods. Otherwise, expenses for long-term/intangible assets may need to be immediately recognized.
In essence, the existence of going concern means the business is expected to operate rather than wind down. This allows standard accounting policies under this assumption. Users of financial statements, like investors and creditors, rely heavily on these standards being followed to analyze performance.
Assessing Going Concern in Auditing
Auditors play a critical role in evaluating and highlighting risks around an entity's ability to continue operating as a going concern. As part of annual audits, auditors must:
- Analyze management's going concern assessment - Auditors review cash flow forecasts, liquidity sources, loan covenants, etc.
- Consider conditions that could indicate going concern problems - Recurring losses, loan defaults, lawsuits, and labor issues are examples.
- Assess probability and timing of conditions resolving favorably
- Determine if substantial doubt exists about the entity's ability to operate over 12 months
- Issue a modified audit opinion when substantial doubt exists, with an explanatory paragraph about the going concern uncertainty
Auditors follow strict guidelines (SAS No. 132) around going concern evaluation, documentation, and reporting. Their independent assessment provides assurance to financial statement users about the appropriateness of management's going concern conclusions.
What is the meaning of going concern?
Going concern is an accounting concept that assumes a company will continue operating indefinitely into the future. It implies that the business has sufficient resources to continue operations and meet its obligations over the next 12 months.
Some key points about the going concern concept:
-
Financial statements are prepared under the assumption that the company is a going concern. This means the business is expected to generate enough cash to pay its debts and continue normal operations.
-
If there is significant doubt about an entity's ability to operate as a going concern, the company must include going concern disclosures in the footnotes of its financial statements. This indicates the business may not be able to meet its obligations over the next year.
-
Auditors evaluate if there is substantial doubt about an entity's going concern status during the audit. The auditor's report may include an explanatory paragraph to highlight the financial difficulties facing the company.
-
Indicators that a company may not be a going concern include consecutive years of net losses, deficient working capital, impending loan defaults, denial of trade credit from suppliers, and other signs of financial distress.
-
If a company is no longer a going concern, its financial statements may need to be prepared on an alternate basis rather than assuming indefinite continuity of operations. Assets may be valued for liquidation rather than as a going concern.
In summary, the going concern concept is fundamental in financial reporting. It assumes a company has the means to sustain itself as a viable business for the foreseeable future, usually regarded as within one year from the financial statement date. Significant doubts about going concern need to be disclosed and could result in modified financial statements.
What is the concept of going concern?
The going concern concept is an important principle in accounting and auditing. It assumes that a company will continue operating in the foreseeable future and will not go out of business or liquidate. This allows the company to recognize long-term assets and liabilities on its balance sheet.
Some key points about the going concern concept:
-
It underpins the way financial statements are prepared. Assets and liabilities are recorded under the assumption that the company will continue to operate.
-
Auditors assess if there is substantial doubt about an entity's ability to continue as a going concern. If so, they may issue a modified audit opinion.
-
Companies are required to make going concern assessments when preparing financial statements. They evaluate if conditions or events cast doubt on their ability to operate in the next 12 months.
-
Indicators of possible financial distress include recurring operating losses, working capital deficiencies, loan defaults, and other adverse financial ratios.
-
If the going concern basis is inappropriate, the financial statements may have to be prepared on an alternate basis such as liquidation. Asset values and liabilities would be adjusted.
In summary, the going concern concept allows companies to prepare financial statements assuming continued operations instead of liquidation. Auditors and management evaluate if there is significant uncertainty about the company's capacity to operate as a going concern.
What is an example of a going concern?
A company that is considered a going concern means it is expected to be able to continue operating and meet its obligations over the next 12 months. Here is an example of a company that would likely qualify as a going concern:
State-Owned Transportation Company
ABC Transport is a state-owned passenger rail service that has been struggling financially due to declining ridership over the past few years. The company has accumulated significant losses and debts that have raised questions about its ability to continue as a going concern.
However, the state government recently approved a financial rescue package for ABC Transport. This includes:
-
A $100 million cash infusion to help the company meet its immediate obligations, such as payroll, supplier payments, etc.
-
Guarantees on $500 million of the company's outstanding debt. This ensures creditors will be paid even if the company defaults.
-
A commitment of further financial support as needed over the next 5 years.
Given this strong backing from the state government, ABC Transport would likely still be considered a going concern that can continue operating despite its financial issues. The state support and guarantees substantially mitigate the risk of bankruptcy or liquidation in the foreseeable future.
So while the company's financial health is poor, the approved government bailout enables ABC Transport to have the necessary resources to keep running its operations and avoid discontinuation. This is a good example of how state intervention can allow a distressed company to maintain going concern status.
Is it good or bad to be a going concern?
A going concern means that a company is financially stable enough to continue operating and meet its obligations for the foreseeable future, which is generally considered to be within one year.
Being a going concern is good because it means:
-
The company is generating enough revenue and cash flow to sustain itself. This demonstrates financial health and viability.
-
The company will likely be able to obtain financing if needed. Lenders and investors want to see a going concern.
-
There is no immediate threat of liquidation or bankruptcy. Business operations can continue.
However, being borderline going concern or subject to substantial doubt can be bad because it indicates:
-
Financial distress or uncertainty about the company's ability to operate in the long run.
-
Potential issues in obtaining financing due to higher risk.
-
Questions about the accuracy of financial statements and accounting methods.
So in summary, although being a going concern is good, operating too close to the threshold may undermine confidence in the business. The optimal situation is maintaining a comfortable buffer above the going concern threshold.
sbb-itb-beb59a9
Evaluating Going Concern: Key Considerations and Factors
Auditors and management consider both quantitative and qualitative factors when assessing an entity's ability to continue operating as a going concern for the next 12 months. This evaluation examines key elements like financial metrics, internal challenges, and external economic conditions that may indicate issues with the entity's prospects.
Analyzing Financial Metrics Indicative of Financial Distress
- Recurring operating losses, working capital deficiencies, and negative cash flows from operations may signify financial distress. Auditors compute financial ratios like the current ratio, debt-to-equity ratio, and days sales outstanding to identify adverse trends over time.
- Missed loan payments, debt covenant violations, and credit downgrades often correlate with going concern risks. Auditors inspect loan agreements and correspondence with lenders as part of their evaluation.
- Revenue declining year-over-year, especially when combined with rising operating expenses, can rapidly erode working capital required to fund continued operations. Trend analysis of financial statement line items helps auditors spot these patterns.
Internal Challenges Impacting Going Concern Status
- Lawsuits, especially those seeking large damages relative to the company's assets, may significantly affect ongoing operations. Auditors review legal correspondence and proceedings for such litigation risks.
- The loss of key customers, critical suppliers, or sole-source components can hinder the ability to continue operating. Auditors may examine concentration ratios, correspondence from lost business partners, and contingency plans.
- Supply chain disruptions, production halts, IT system failures, and other internal incidents may negatively impact prospects if severe enough. Auditors inspect internal memos and incident reports for such risks.
External Economic and Industry Conditions Affecting Going Concern
- Declining economic conditions like recessions may reduce customer demand across an entity's industry. Auditors consider macroeconomic leading indicators when assessing going concern risks.
- Disruptive innovations and technology shifts, such as online streaming replacing video rental stores, may obsolete a company's products or services. Auditors study the competitive landscape and structural industry changes.
- New regulations, like added licensing requirements or bans on certain product ingredients, can fundamentally threaten industries. Auditors review regulatory changes and gauge management's response.
By weighing quantitative metrics and qualitative factors like these, auditors determine if substantial doubt exists regarding the entity's ability to operate as a going concern. The evaluation involves judgment based on the totality of evidence available.
The Auditor's Report and the Going Concern Opinion
When an auditor has substantial doubt about an entity's ability to operate as a going concern, they must issue a modified audit opinion. This section outlines key auditor reporting requirements under Generally Accepted Auditing Standards and Public Company Accounting Oversight Board standards.
Issuing an Emphasis of Matter for Going Concern Uncertainties
Auditors first draw attention to going concern matters through an Emphasis-of-Matter paragraph while still issuing an unmodified opinion. This allows the auditor to highlight the existence of material uncertainties related to events or conditions that may cast doubt on the entity's ability to continue operating as a going concern.
Some key points about Emphasis of Matter paragraphs for going concern:
- They refer the reader to disclosures in the financial statements that discuss the going concern uncertainty
- The auditor still expresses an unmodified opinion on the financial statements
- The Emphasis of Matter paragraph comes after the opinion paragraph
- They draw attention to the going concern disclosure but don't modify the auditor's opinion
By including this Emphasis of Matter paragraph, the auditor alerts financial statement users about the going concern uncertainty without having to issue a modified opinion.
When Auditors Issue Disclaimers and Modified Opinions
If after evaluating management's going concern assessment and related financial statement disclosures, the auditor still has substantial doubt about the entity's ability to operate in the foreseeable future, they will issue either a disclaimer opinion or an adverse opinion.
Some key differences between disclaimer and adverse opinions:
- Disclaimer - Declines to express an opinion due to limitation of scope or lack of sufficient audit evidence related to going concern
- Adverse - Expresses an adverse opinion when financial statements are materially misstated due to inadequate going concern disclosures
The type of modified opinion depends on the auditor's judgment regarding the adequacy of financial statement presentation and disclosures for the going concern uncertainty.
The Significance of Communicating Going Concern in the Auditor's Report
For public companies, auditing standards require the auditor to designate going concern as a Critical Audit Matter (CAM) when substantial doubt exists and it required especially challenging, subjective, or complex judgment. The CAM is presented in a separate section of the audit report explaining:
- Why the matter is a CAM
- How it was addressed in the audit
- The relevant financial statement accounts and disclosures
Including going concern uncertainties as a CAM underscores their importance and signals to financial statement users that this issue could have a material impact on the financial statements.
Drawing attention to going concern through Emphasis of Matter paragraphs, modified opinions, and CAM communications enables the auditor to highlight uncertainties, deficiencies, and risks for the benefit of report users. This facilitates more transparent financial reporting.
Management's Role in Going Concern Assessment and Disclosure
Management has important duties in assessing and disclosing uncertainties about an entity's ability to continue as a going concern. These responsibilities work in conjunction with the auditor's assessment.
Conducting Thorough Going Concern Analysis and Documentation
If substantial doubt exists regarding the company's going concern status, management must:
- Thoroughly analyze the situation, including plans to mitigate the concerns
- Properly document the analysis
- Provide going concern disclosures in financial statement footnotes
This analysis involves assessing working capital, cash flows, profitability trends, debt payment schedules, and other factors over the foreseeable future.
Management should supplement financial statements with plans to alleviate doubts about the going concern assumption. For example, plans to:
- Restructure debt
- Raise additional capital
- Reduce expenses
Mandatory Going Concern Disclosures in Financial Statements
When substantial doubt exists, auditing standards require auditors to include an explanatory paragraph in their report. Management must also include going concern disclosures in the notes of the financial statements.
These disclosures should provide details on:
- Conditions giving rise to the substantial doubt
- Mitigating factors and management plans
- Possible effects on the financial statements
Proper disclosures inform financial statement users and help them make decisions regarding the company.
Adhering to Accounting Standards for Going Concern Reporting
Entities reporting under Generally Accepted Accounting Principles (GAAP) have responsibilities around going concern assumptions and disclosures. Similar duties exist under:
- International Financial Reporting Standards (IFRS)
- Governmental Accounting Standards Board (GASB)
- Financial Accounting Standards Board (FASB)
So while specifics may vary, the overall requirement to assess and disclose going concern uncertainties is consistent across accounting frameworks. Appropriate analysis, documentation, and disclosure are critical.
Strategic Actions to Mitigate Going Concern Risks
Companies facing going concern issues can take proactive steps to improve their financial stability. Some strategies include:
Securing New Capital Investment to Support Going Concern
-
Seeking new investors or additional equity financing can provide much-needed working capital. This injects funds to continue operations in the short term while implementing longer-term strategies.
-
Selling off non-core assets is another way to raise capital and reduce expenses related to unused or underperforming business units. The influx of cash can fund daily activities.
Effective Debt Restructuring and Cost Reduction Strategies
-
Renegotiating the terms of existing debts, such as extending payment deadlines, can improve cash flow available for operations. This provides financial breathing room.
-
Reducing operating costs through layoffs, office closures, inventory cuts, and other austerity measures decreases cash outflow. Lowering expenses increases the chance of maintaining positive cash flow.
Renegotiating Debt Covenants to Improve Liquidity
-
Making debt covenants less strict can reduce the risk of defaulting on loans and going bankrupt. More lenient covenants may give access to additional financing.
-
Lowering interest rates through new agreements with lenders reduces interest expenses paid, retaining more cash for operational needs and increasing liquidity.
In summary, struggling companies can mitigate going concern risks through capital infusion, cost-cutting, debt restructuring, asset sales, and updated operations. Taking decisive action improves the financial position.
The Implications of Going Concern Failure and Financial Distress
When a company can no longer operate as a going concern, outcomes typically involve bankruptcy, asset liquidation, and other significant impacts. Understanding these potential consequences can help businesses take preventative measures.
Navigating Bankruptcy as the Opposite of Going Concern
Ongoing losses may eventually force distressed entities to file for Chapter 7 or Chapter 11 bankruptcy protection to restructure debt and operations.
-
Chapter 7 bankruptcy leads to appointing a trustee to oversee liquidating assets to pay creditors. This often results in dissolving the business.
-
Under Chapter 11, the company attempts to reorganize and emerge from bankruptcy as an ongoing business. This involves developing a court-approved restructuring plan with input from creditors.
In either case, the bankruptcy process is complex and the outcomes uncertain. Legal and administrative costs are high. Companies may end up sold, merged, or dissolved. Equity shareholders usually lose investment value.
The Process and Consequences of Asset Liquidation
If reorganizing under bankruptcy is not feasible, companies may be forced to sell property, inventory, equipment, and other assets before dissolving.
-
Liquidation sales bring only a fraction of asset market value. Assets may be outdated or tailored to the specific business, limiting buyer options.
-
Employees lose jobs. Value disappears for shareholders and creditors. The business ultimately ceases operations.
-
There are also reputation impacts. Customers lose confidence in failed brands and may shift business elsewhere.
Forced liquidation is extremely detrimental for all stakeholders. Managing solvency and preventing distress early on is critical.
Understanding Stakeholder Impacts in Going Concern Failures
When entities can no longer operate as going concerns, wide-ranging stakeholder groups face consequences:
Suppliers lose a business customer. They may not receive payments owed for past orders. This contributes to a negative ripple effect on local economies.
Employees lose jobs instantly. Severance pay or pension access may be limited. Workers must unexpectedly hunt for new jobs.
Shareholders lose entire investment value. Equity is typically wiped out in liquidations or restructuring plans.
Creditors and lenders receive only a portion of amounts owed. They face major write-downs on debt obligations.
Customers must abruptly shift business to new suppliers. They may face higher prices or service gaps. Brand trust deteriorates.
The stakeholder damage from going concern failure underlines the importance of proactive financial management, solvency protection, and turnaround planning.
Conclusion: Emphasizing the Importance of Going Concern in Corporate Finance
The going concern concept is a fundamental principle in financial reporting, auditing, and business continuity planning. By monitoring key metrics, companies can mitigate substantial doubt about their ability to continue operations.
Summarizing Going Concern's Impact on Financial Reporting
The going concern assumption affects how companies:
- Value assets and liabilities on their balance sheets
- Recognize revenues and expenses on income statements
- Assess liquidity and capital needs in their cash flow statements
If there is substantial doubt about a company's going concern status, it may have to adjust its financial statements to reflect liquidation basis accounting rather than standard accounting rules and principles.
Reflecting on the Critical Role of Auditors and Regulatory Guidance
Auditors analyze going concern issues closely due to their visibility and consequences for stakeholders. Auditors apply regulatory guidance from the PCAOB, GAAS, FASB, and AICPA when evaluating whether there is substantial doubt about an entity's ability to continue as a going concern.
If an auditor determines that there is substantial doubt, they would issue a modified audit opinion with an explanatory paragraph about the going concern uncertainty.
Strategies for Mitigating Substantial Doubt and Ensuring Continuity
To mitigate substantial doubt and ensure business continuity, companies can proactively:
- Inject additional capital from investors
- Reduce operating costs and overheads
- Renegotiate loan and debt terms with lenders
Implementing such strategies requires careful cash flow forecasting, liquidity planning, and communication with stakeholders about risks and continuity plans.
