What Is the Going Concern Assumption?

The “going concern assumption” is a fundamental principle in financial accounting. It presumes that a business entity will continue to operate for the foreseeable future, rather than liquidating or ceasing operations. This assumption allows for accrual accounting, where revenues and expenses are recognized when earned or incurred, regardless of when cash changes hands.

This principle dictates how assets and liabilities are valued and presented on a company’s balance sheet. Without the expectation of continued operation, a different accounting approach would be necessary, altering the financial picture of a business. The going concern assumption underpins the relevance and reliability of financial information for various users.

Understanding the Going Concern Assumption

The going concern assumption posits that a business will continue operations for at least 12 months from the date financial statements are issued. This timeframe is standard for assessing a company’s ability to meet its obligations. The Financial Accounting Standards Board (FASB) addresses this concept in its Accounting Standards Codification (ASC) 205-40, which outlines requirements for management’s evaluation.

Under this assumption, a company’s assets are valued at their historical cost less depreciation, rather than their liquidation value. For example, machinery purchased for production is recorded at its original cost and depreciated over its useful life. If the going concern assumption were not in place, assets would instead be valued at what they could be sold for in a quick sale.

Similarly, liabilities are presented based on their contractual terms and expected payment dates, assuming the business will generate sufficient cash flows to settle them. This includes recognizing deferred revenue or long-term debt. If a company were not considered a going concern, a “liquidation basis of accounting” would be required, where assets are measured at estimated disposal amounts and liabilities at expected settlement values. This alternative basis would change how financial performance and position are reported.

Why the Going Concern Assumption Matters

The going concern assumption is important for various stakeholders who rely on financial statements to make informed decisions. For investors, it is a key element in assessing a company’s long-term viability and potential for future returns. An investor considering purchasing stock anticipates that the company will continue to operate and grow, generating profits and potential dividends.

Creditors depend on this assumption when evaluating a company’s ability to repay loans or fulfill trade credit obligations. They assess the likelihood of a business generating sufficient cash flow from its operations to meet its financial commitments. If a company is not expected to continue, creditors face a higher risk of default, which influences lending decisions and terms.

Management uses the going concern assumption for strategic planning and operational decisions, including budgeting, capital expenditure planning, and employee retention. It provides a framework for forecasting future performance and setting business objectives. Without this assumption, long-term strategic initiatives would be less relevant, as the focus would shift to immediate asset disposition.

Signs of Going Concern Uncertainty

Indicators can suggest that a company’s ability to continue as a going concern may be in doubt. These signs often fall into financial, operational, and other categories. Financial indicators include recurring operating losses, negative cash flows from operations, and significant working capital deficiencies. An inability to pay debts as they become due also signals financial distress.

Operational indicators might involve the loss of key management personnel, labor difficulties, or the loss of a major customer or supplier. Dependence on a single product or project can also create vulnerability. A failure to re-invest in new product development or a decline in demand for existing products can weaken future prospects.

Other indicators include non-compliance with legal or regulatory requirements, or pending legal proceedings that could result in financial penalties. Denial of trade credit from suppliers or the need to seek less favorable financing also points to potential issues. These factors can collectively raise substantial doubt about a company’s ability to continue operations.

What Happens When Going Concern is Questioned

When substantial doubt about a company’s ability to continue as a going concern arises, specific actions are required in financial reporting. Under U.S. GAAP, management must evaluate whether conditions or events raise substantial doubt about the entity’s ability to meet its obligations within one year after the financial statements are issued. If such doubt exists, even if management’s plans alleviate it, specific disclosures are mandated.

These disclosures must describe the conditions or events that raised the doubt and management’s evaluation. If management has plans to mitigate the uncertainty, those plans must also be disclosed. If substantial doubt is not alleviated by management’s plans, the notes must state that substantial doubt exists about the entity’s ability to continue as a going concern.

Auditors evaluate management’s assessment. If the auditor concludes that substantial doubt exists and disclosures are adequate, the auditor’s report will include an “emphasis-of-matter” paragraph. This paragraph highlights the uncertainty without modifying the audit opinion, directing users to the relevant disclosures. If disclosures are inadequate, the auditor may issue a qualified or adverse opinion.