Going Concern Concept
A going concern is an accounting term used for a business that is assumed to be capable of continuing its operations and meeting its financial obligations as and when they become due. Under this concept, the business is expected to operate without the immediate threat of liquidation or closure for the foreseeable future.
The foreseeable future is generally considered to be at least the next 12 months or the specified accounting period, whichever is longer. The going concern assumption therefore reflects the basic intention that an entity will continue its normal business activities for at least the near future.
The presumption of going concern is an important assumption used in the preparation of financial statements under the conceptual framework of International Financial Reporting Standards (IFRS). When an entity prepares accounts on a going concern basis, it is assumed that the business neither intends nor needs to liquidate, cease trading, or materially reduce the scale of its operations.
Thus, the going concern concept is based on the continuity of business operations. The entity is expected to continue its activities and fulfil its obligations through the normal course of business.
Going Concern Basis and Liquidation Basis of Accounting
The continuation of an entity as a going concern is normally presumed for financial reporting unless and until liquidation of the entity becomes imminent. Financial statements prepared on this assumption are said to be prepared using the going concern basis of accounting.
Under the going concern basis, the business is treated as a continuing economic entity. Assets and liabilities are accounted for on the assumption that normal business operations will continue.
However, when the liquidation of an entity becomes imminent, the going concern assumption is no longer appropriate. In such circumstances, financial statements are prepared under the liquidation basis of accounting.
Therefore, the basis of financial reporting depends on whether the entity is expected to continue its normal business activities or is approaching liquidation.
Definition and Development of the Going Concern Assumption
The going concern assumption is widely understood and accepted by accounting professionals. However, historically, the concept was not formally incorporated into U.S. Generally Accepted Accounting Principles (GAAP).
In October 2008, the Financial Accounting Standards Board (FASB) issued an Exposure Draft titled “Going Concern.” The Exposure Draft discussed several important issues relating to the going concern concept.
The issues considered included the definition and incorporation of the terms “going concern” and “substantial doubt” into U.S. GAAP. It also considered the period or time horizon over which management should evaluate the ability of an entity to meet its financial obligations.
The Exposure Draft further considered the type of information that management should examine while evaluating the entity’s ability to meet its obligations. It also examined the effect of subsequent events on management’s going concern assessment and whether specific guidance should be provided regarding the liquidation basis of accounting.
Meaning of Going Concern under Auditing Standards
The going concern concept assumes that a business will remain in existence for a sufficiently long period to fully utilise its assets. In this context, utilisation of an asset means obtaining the complete benefit from its earning potential.
For example, suppose a business purchases equipment for $5,000 with a productive or useful life of five years. Under the going concern assumption, the accountant assumes that the business will continue to use the equipment throughout its useful life.
Accordingly, only one year’s value of $1,000, that is one-fifth of the equipment cost, is written off during the current year. The remaining $4,000 continues to be treated as a fixed asset having future economic value for the business.
This accounting treatment is based on the assumption that the business will continue operating and will obtain economic benefits from the asset in future accounting periods.
Going Concern in the UK and Republic of Ireland
Financial Reporting Standards in the United Kingdom and the Republic of Ireland provide that an entity is considered a going concern unless management intends to liquidate the entity, intends to cease trading, or has no realistic alternative other than liquidation or cessation of trading.
While assessing whether the going concern assumption is appropriate, management must consider all available information about the future. The assessment period must cover at least 12 months from the date on which the financial statements are authorised for issue, although the assessment is not necessarily limited to 12 months.
These requirements establish a relatively high threshold for concluding that an entity should not be reported as a going concern. Financial statements may continue to be prepared on a going concern basis with appropriate disclosures even when significant judgement is required to reach the going concern conclusion.
Similarly, accounts may be prepared on a going concern basis where a material uncertainty related to going concern exists, provided appropriate disclosures are made. An explicit statement is also required confirming that the financial statements have been prepared on a going concern basis.
Accounting Treatment under the Going Concern Principle
The going concern principle allows a company to defer certain prepaid expenses to future accounting periods. This treatment is possible because the business is expected to continue its activities in future periods.
The going concern assumption is a fundamental assumption in the preparation of financial statements. Under this assumption, an entity is ordinarily considered to continue in business for the foreseeable future without the intention or necessity of liquidation, cessation of trading, or seeking protection from creditors under applicable laws or regulations.
When the going concern assumption is appropriate, assets and liabilities are recorded on the assumption that the entity will be able to realise its assets and discharge its liabilities in the normal course of business. It is also assumed that the entity will be able to obtain refinancing, if required, during its normal business operations.
Therefore, assets are not normally valued merely on the basis of an immediate forced sale. Similarly, liabilities are considered in the context of the continuing operations of the entity.
Information Contrary to the Going Concern Assumption
An entity is normally assumed to be a going concern unless significant information indicates otherwise. Such contrary information may create doubt regarding the entity’s ability to continue normal operations.
For example, an entity may be unable to meet its financial obligations as they become due without undertaking substantial asset sales or major debt restructuring. Such circumstances may indicate problems with the entity’s ability to continue as a going concern.
Without the going concern assumption, a business would effectively be considered as purchasing assets with the intention of closing its operations and subsequently reselling those assets to another party. This is different from the normal purpose of acquiring assets for use in continuing business operations.
Effect When an Entity Is No Longer a Going Concern
If an accountant believes that an entity may no longer continue as a going concern, the valuation of assets and recognition of liabilities may require reconsideration.
One important issue is whether the entity’s assets are impaired. The carrying amount of an asset may need to be written down to its liquidation value if the business is approaching closure.
The entity may also need to recognise liabilities arising because of its imminent closure. Such liabilities may not have arisen if the business had continued its normal operations.
The value of an entity operating as a going concern is generally higher than its breakup value. This is because a continuing business has the potential to earn profits in the future. In contrast, breakup value is based on the value of the entity when its operations are discontinued and its assets are separated or disposed of.
Role of the Auditor in Evaluating Going Concern
The going concern concept historically lacked a clear definition within U.S. GAAP and was therefore subject to interpretation regarding the circumstances in which an entity should report going concern issues. However, Generally Accepted Auditing Standards (GAAS) provide guidance to auditors regarding the evaluation of an entity’s ability to continue as a going concern.
An auditor evaluates the entity’s ability to continue as a going concern for a period of not less than one year following the date of the financial statements being audited. A longer period may also be considered when the auditor believes that the extended period is relevant.
During this evaluation, the auditor considers various conditions that may create substantial doubt about the entity’s ability to continue operations. These may include negative trends in operating results, loan defaults, denial of trade credit by suppliers, uneconomical long-term commitments, and legal proceedings.
If the auditor concludes that substantial doubt exists regarding the entity’s ability to continue as a going concern, the auditor must draw attention to this uncertainty in the auditor’s report.
However, if an entity has inappropriately used the going concern assumption while preparing its financial statements, the auditor may issue an adverse opinion on the financial statements.
Guidance relating to going concern also provides a framework for directors, audit committees, and finance teams to determine whether the going concern basis is appropriate for preparing financial statements. It also assists them in making balanced, proportionate, and clear disclosures.
Going Concern Assumption in Financial Statements
Under the going concern assumption, an entity is considered to continue its business activities for the foreseeable future. General purpose financial statements are normally prepared on a going concern basis.
However, the going concern basis is not appropriate when management intends to liquidate the entity, intends to cease operations, or has no realistic alternative but to do so.
Special purpose financial statements may or may not use a financial reporting framework in which the going concern basis is relevant. For example, in certain jurisdictions, the going concern basis may not be relevant for some financial statements prepared on a tax basis.
When the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will realise its assets and discharge its liabilities in the normal course of business.
Standards and Guidance on Going Concern
Under the International Standards on Auditing (ISA), auditors are required to evaluate whether management’s use of the going concern basis is appropriate. Auditors must also determine whether a material uncertainty relating to going concern exists.
ISA 570 (Revised) prescribes specific reporting requirements when going concern uncertainties are present. These requirements are effective for periods ending on or after 15 December 2016.
In the United States, FASB requires management to assess going concern uncertainties and provide disclosures when necessary. Under ASC 205-40, management evaluates going concern uncertainties for the one-year period after the date on which the financial statements are issued or are available to be issued. This requirement was introduced through ASU 2014-15.
For audits of U.S. issuers, the Public Company Accounting Oversight Board (PCAOB) requires auditors to evaluate whether substantial doubt exists regarding an entity’s ability to continue as a going concern. Under AS 2415, the auditor must appropriately modify the auditor’s report when required.
Use of Going Concern Information in Risk Management
A report expressing doubts about a company’s ability to continue as a going concern may be viewed by investors as an indication of increased financial risk. However, an emphasis of matter paragraph in an audit report does not necessarily mean that the company is immediately approaching insolvency.
Despite this, some fund managers may be required to sell the company’s shares to maintain an appropriate level of risk in their investment portfolios.
A negative going concern judgement may also result in a breach of bank loan covenants. A debt rating firm may reduce the credit rating of the company’s debt. A lower rating may increase the cost of existing debt and may also make it difficult for the company to obtain additional debt financing.
The expression of going concern uncertainty by an auditor can itself influence the financial position of a company. In the 1970s, the AICPA’s Cohen Commission observed that an auditor’s expression of uncertainty about a company’s ability to continue may become a “self-fulfilling prophecy.”
This means that the expression of uncertainty may itself contribute to worsening the company’s financial difficulties and may increase the possibility of business failure.
Businesses experiencing financial difficulties should communicate with their business advisers and auditors. Effective communication allows advisers and auditors to provide assistance when required. They can also help the business review its internal risk management and other internal controls.
Exam Focus
A going concern is an entity expected to continue operations and meet its obligations as they become due without the intention or necessity of liquidation or material curtailment of operations. The going concern assumption is a fundamental assumption in the preparation of financial statements.
Financial statements are prepared on the going concern basis unless liquidation becomes imminent. When liquidation becomes imminent, the liquidation basis of accounting is used.
Under the going concern assumption, assets and liabilities are recorded on the basis that the entity will realise its assets and discharge its liabilities in the normal course of business. A going concern generally has a value higher than its breakup value because it has the potential to earn future profits.
The auditor considers factors such as negative operating trends, loan defaults, denial of trade credit, uneconomical long-term commitments, and legal proceedings while evaluating going concern uncertainty. If substantial doubt exists, the auditor draws attention to the uncertainty in the audit report. Inappropriate use of the going concern assumption may result in an adverse audit opinion.
ISA 570 (Revised) deals with going concern under International Standards on Auditing. In the United States, ASC 205-40 requires management to assess going concern uncertainties, while PCAOB AS 2415 deals with the auditor’s evaluation of substantial doubt regarding an entity’s ability to continue as a going concern.