Going Concern Assumption Accounting Concept + Examples

As companies have been upended by the pandemic, high inflation and pummeled by rising interest rates, going-concern warnings in company filings have spiked, according to Audit Analytics, a research firm. No single factor spells imminent doom for a business, but there are red flags that can signal trouble. And while our site doesn’t feature every company or financial product available on the market, we’re proud that the guidance we offer, the information we provide and the tools we create are objective, independent, straightforward — and free. Going-concern warnings cropped up recently in filings from Bed Bath & Beyond, Vice Media and Virgin Orbit, presaging their eventual bankruptcies.

1. The going concern approach utilizes the standard intrinsic and relative valuation approaches, with the shared assumption that the company (or companies) will be operating perpetually.
2. For example, a company’s annual expenses may so vastly outweigh its revenue that it can’t reasonably make a profit.
3. The going-concern value of a company is typically much higher than its liquidation value because it includes intangible assets and customer loyalty as well as any potential for future returns.
4. Continuation of an entity as a going concern is presumed as the basis for financial reporting unless and until the entity’s liquidation becomes imminent.

In the context of corporate valuation, companies can be valued on either a going concern basis or a liquidation basis. In the absence of the going concern assumption, companies would be required to recognize asset values under the implicit assumption of impending liquidation. For instance, the value of fixed assets (PP&E) is recorded at their original historical cost and depreciated over their useful life, i.e. the expected number of years in which the fixed asset will continue to contribute positive economic value. However, liquidating a company means laying off all of its employees, and if the company is viable, this can have negative ramifications not only for the laid-off workers but also for the investor who made the decision to liquidate a healthy company.

Auditors Concerns Over a Negative Opinion

A going concern is often good as it means a company is more likely than not to survive for the next year. When a company does not meet the going concern criteria, it means that a company may not have the resources needed to operate over the next 12 months. There are also a number of quantifiable, measurable indicators that auditors use to measure going concern. Companies with low liquidity ratios, high employee turnover, or decreasing market share are more likely to not be a going concern.

Management is required to disclose this fact and must provide the reasons why they may not be a going concern. Management must also identify the basis in which the financial statements are prepared and often disclose these financial reports with an audit report with a going concern opinion. Accounting standards try to determine what a company should disclose on its financial statements minimum level of stock explanation formula example if there are doubts about its ability to continue as a going concern. In May 2014, the Financial Accounting Standards Board determined financial statements should reveal the conditions that support an entity’s substantial doubt that it can continue as a going concern. Statements should also show management’s interpretation of the conditions and management’s future plans.

A firm’s inability to meet its obligations without substantial restructuring or selling of assets may also indicate it is not a going concern. If a company acquires assets during a time of restructuring, it may plan to resell them later. Consider how a single substantial lawsuit, default on a loan, or defective product can jeopardize the future of a company.

When the financial statements are prepared for the annual report, it is the job of the Board of Directors to decide if the company is still a going concern. The Board must put this information into the footnotes included in the financial statements and state any factors that may threaten that status. The going concern concept is not clearly defined anywhere in generally accepted accounting principles, and so is subject to a considerable amount of interpretation regarding when an entity should report it. However, generally accepted auditing standards (GAAS) do instruct an auditor regarding the consideration of an entity’s ability to continue as a going concern.

Consequences of a Negative Going Concern Opinion

If the auditor determines the plan can be executed and mitigates concerns about the business, then a qualified opinion will not be issued. An entity is assumed to be a going concern in the absence of significant information to the contrary. An example of such contrary information is an entity’s inability to meet its obligations as they come due without substantial asset sales or debt restructurings. If such were not the case, an entity would essentially be acquiring assets with the intention of closing its operations and reselling the assets to another party. Most troubling is that auditors might fail to issue a negative going concern opinion because of the lack of auditor independence. Management determines the auditor’s tenure and remuneration and can hire and fire the auditor at will.

If a company receives a negative audit and may not be a going concern, there are several implications. Companies that are not a going concern represent a significantly higher level of risk compared to other companies. In order for a company to be a going concern, it usually needs to be able to operate with a significant debt restructuring or massive financing overhaul. Therefore, it may be noted that companies that are not a going concern may need external financing, restructuring, asset liquidation, or be acquired by a more profitable entity.

In the case there is substantial yet unreported doubt about the company’s continuance after the date of reporting (i.e. twelve months), then management has failed its fiduciary duty to its stakeholders and has violated its reporting requirements. Even if the company’s future is questionable and its status as a going concern appears to be in question – e.g. there are potential catalysts that could raise significant concerns – the company’s financials should still be prepared on a going concern basis. The reason the going concern assumption bears such importance in financial reporting is that it validates the use of historical cost accounting.

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They can help business review their internal risk management along with other internal controls. Also significant is the fact that if a business is determined to be a going concern that means that it can pay its liabilities and realize its assets. The company’s auditor is the employee who must determine whether or not the company is still a going concern and they report their findings to the Board of Directors. The auditor https://www.quick-bookkeeping.net/how-to-charge-interest-on-an-invoice/ is required to disclose any negative trends in the company’s business operations. Negative trends include such things as lower operating income, loan denials, loan defaults, repossession of assets, and more. Once this is done, the auditor must issue a “going concern opinion” which means that the entity has neither the intention (nor the need) to liquidate or curtail in any material way the scale of its operations.

Companies that are a going concern may defer reporting long-term assets at current value or liquidating value, but rather at cost. A company remains a going concern when the sale of assets does not impair its ability to continue operation, such as the closure of a small branch office that reassigns the employees to other departments within the company. In accrual accounting, the financial statements are prepared under the going concern assumption, i.e. the company will remain operating into the foreseeable future, which is formally defined as the next twelve months at a bare minimum. The auditor is required by the Securities and Exchange Commission to disclose in the financial statements of a publicly traded company whether going concern status is in doubt.

Liquidating a going concern can give an investor a bad reputation among potential future takeover targets. The dreaded warning, usually buried in the fine print, often leads to sharp declines in a company’s stock price, angst for creditors and worries among employees. But the term is rarely brought up unless a company is in trouble — that is, in cases where it has doubts it could continue as a going concern.