Going Concern Definition, Principle and Red Flags

Going Concern Definition, Principle and Red Flags

Similarly, US GAAP financial statements are prepared on a going concern basis unless liquidation is imminent. Disclosures are required if events and circumstances raise substantial doubt about the entity’s ability to continue as a going concern. Although the terminology varies slightly, both GAAPs share the same objective of informing users of the financial statements early about the company’s potential financial difficulties. When management becomes aware of material uncertainties related to events or conditions that may cast significant doubt on the company’s ability to continue as a going concern, those uncertainties must be disclosed in the financial statements. The terms ‘material uncertainties’ and ‘significant doubt’ are important – this standard phrasing is expected to be used in the basis of preparation note to the financial statements. Management’s going concern assessment may be significantly affected by the current economic environment.

  1. Without it, business would not offer nearly as much credit sales as suppliers, vendors, and other companies may not pay the company if there is little belief these companies will survive.
  2. A qualified opinion can be a concern to investors, lenders and other stakeholders.
  3. Similarly ISA 580, Written Representations recognises that while written representations do provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the matters with which they deal.

A qualified opinion can be a concern to investors, lenders and other stakeholders. An important point to emphasise at the outset is that candidates are strongly advised not to use the ‘scattergun’ approach when it comes to deciding on the audit opinion to be expressed within the auditor’s report. This is where a candidate explores all possible options rather than  coming to a conclusion as to the auditor’s opinion, depending on the circumstances presented in the question. It is essential that candidates preparing for the Audit and Assurance (AA) exam understand the respective responsibilities of auditors and management regarding going concern. This article discusses these responsibilities, as well as the indicators that could highlight where an entity may not be a going concern, and the reporting aspects relating to going concern.

Going concern concept example

The auditor evaluates an entity’s ability to continue as a going concern for a period not less than one year following the date of the financial statements being audited (a longer period may be considered if the auditor believes such extended period to be relevant). If so, the auditor must draw attention to the uncertainty regarding the entity’s ability to continue as a going concern, in their auditor’s report. Separate standards and guidance have been issued by the Auditing Practices Board to address https://www.wave-accounting.net/ the work of auditors in relation to going concern. To meet these disclosure requirements, in our view, similar information to that in respect of material uncertainties may be relevant to the users’ understanding of the company’s financial statements, as appropriate. As mentioned earlier, it is not the auditor’s responsibility to determine whether, or not, an entity can prepare its financial statements using the going concern basis of accounting; this is the responsibility of management.

Disclosure of a going concern qualification

If the auditor concludes that the disclosures are inadequate, or if management have not made any disclosure at all and management refuse to remedy the situation, the opinion will be qualified or adverse. By contrast, the going concern assumption is the opposite of assuming liquidation, which is defined as the process when a company’s operations are forced to a halt and its assets are sold to willing buyers for cash. Often, management will be incentivized to downplay the risks and focus on its plans to mitigate the conditional events – which is understandable given their duties to uphold the valuation (i.e. share price) of the company – yet the facts must still be disclosed.

Mitigation of a qualified opinion

Preparation of financial statements under this presumption is commonly referred to as the going concern basis of accounting. If and when an entity’s liquidation becomes imminent, financial statements are prepared under the liquidation basis of accounting (Financial Accounting Standards Board, 2014[1]). A going concern is an accounting term for a business that is assumed will meet its financial obligations when they become due.

These examples are programmatically compiled from various online sources to illustrate current usage of the word ‘going concern.’ Any opinions expressed in the examples do not represent those of Merriam-Webster or its editors. © 2024 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. 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. Liquidating a going concern can give an investor a bad reputation among potential future takeover targets. A going concern is often good as it means a company is more likely than not to survive for the next year.

In addition, management must include commentary regarding its plans on how to alleviate the risks, which are attached in the footnotes section of a company’s 10-Q or 10-K. Under GAAP standards, companies are required to disclose material information that enables their viewers – in particular, its shareholders, lenders, etc. – to understand the true financial health of the company. The reason the going concern assumption bears such importance in financial reporting is that it validates the use of historical cost accounting.

Under US GAAP, management’s plans are ignored under Step 1 of the going concern assessment. Their mitigating effect is considered under Step 2 to determine if they alleviate the substantial doubt raised in Step 1, but only if certain conditions are met. This means management needs to run two sets of forecasts, before and after management’s plans, whereas IFRS Standards are not prescriptive in this regard. Management has taken steps to address these issues and is working to improve the company’s financial performance. If the company is unable to generate sufficient revenue or secure additional financing, it may be unable to meet its obligations and may be forced to cease operations.

Thus, the value of an entity that is assumed to be a going concern is higher than its breakup value, since a going concern can potentially continue to earn profits. 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. This assumption allows businesses to continue operating without needing to be liquidated or wound down in the event of financial difficulty.

The Going Concern Assumption is a fundamental principle in accrual accounting, stating that a company will remain operating into the foreseeable future rather than undergo a liquidation. Plummeting cash flow and ballooning debt can be obvious signs of trouble, but nonfinancial factors can also sink a business, like legal issues, changes in regulation or the resignation of a key accountant for self employed executive. The going concern assessment is inherently complex and judgmental and will be under heightened scrutiny for many companies this year due to COVID-19. Management should carefully consider the requirements of IFRS Standards and reevaluate their historical approach to the going concern analysis; it may no longer be sufficient given the current economic environment.

Because the US GAAP guidance is more developed in this area, it may provide certain useful reference points for IFRS Standards preparers – e.g. to identify adverse conditions and events or to assess the mitigating effects of management’s plans. However, dual reporters should be mindful of the differing frameworks, terminologies and potentially different outcomes in their going concern conclusions. Our IFRS Standards resources will help you to better understand the potential accounting and disclosure implications of COVID-19 for your company, and the actions management can take now. Management may have a history of successful refinancing or carrying out other plans.

Listing the value of long-term assets may indicate a company plans to sell these assets. In this example it is clear that the going concern basis is inappropriate in the entity’s circumstances. The directors have no realistic alternative but to liquidate in order to raise funds to pay back the bank and the bank have already confirmed that they will commence legal proceedings to force the entity into selling off assets to raise finance to repay their borrowings. 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.

It functions without the threat of liquidation for the foreseeable future, which is usually regarded as at least the next 12 months or the specified accounting period (the longer of the two). The presumption of going concern for the business implies the basic declaration of intention to keep operating its activities at least for the next year, which is a basic assumption for preparing financial statements that comprehend the conceptual framework of the IFRS. Hence, a declaration of going concern means that the business has neither the intention nor the need to liquidate or to materially curtail the scale of its operations.

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However, generally accepted auditing standards (GAAS) do instruct an auditor regarding the consideration of an entity’s ability to continue as a going concern. The “going concern” principle is a fundamental concept in accounting that assumes that a business will continue to operate for the foreseeable future. This means that companies should not only be able to cover their current operating costs but also have enough resources and earn profits to meet their long-term liabilities. If there are any material uncertainties relating to the going concern assumption, then management must make adequate going concern disclosures in the financial statements. At the end of the day, awareness of the risks that place the company’s future into doubt must be shared in financial reports with an objective explanation of management’s evaluation of the severity of the circumstances surrounding the company.

Going concern is an example of conservatism where entities must take a less aggressive approach to financial reporting. Accountants who view a company as a going concern generally believe a firm uses its assets wisely and does not have to liquidate anything. Accountants may also employ going concern principles to determine how a company should proceed with any sales of assets, reduction of expenses, or shifts to other products.

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