Going concern
Encyclopedia
A going concern is a business
that functions without the threat of liquidation
for the foreseeable future, usually regarded as at least within 12 months.
The 'going concern' concept directs accountants to prepare financial statements on the assumption that the business is not about to go broke or be liquidated (i.e. where the business closes and sells all the assets for whatever price they can get).
So, unless there is significant evidence to the contrary, accountants will base their valuations and their reporting of financial data on the assumption that the business will remain in existence for an indefinite period.
An indefinite period means the foreseeable future or long enough for the business to meet its objectives and to fulfill its commitments. It is important to note that the 'going concern' concept does not imply or guarantee that the business is profitable and will remain so for the foreseeable future.
So, the 'going concern' concept assumes that the business will remain in existence long enough for all the assets of the business to be fully utilized. Utilized assets means obtaining the complete benefit from their earning potential. (i.e. if you recently purchased equipment costing $5,000 that had 5 years of productive/useful life, then under the going concern assumption, the accountant would only write off one year's value $1,000 (1/5th) this year, leaving $4,000 to be treated as a fixed asset with future economic value for the business). The 'going concern' concept supports the assumption that when a business buys assets like land, equipment, and buildings, it does so with the intent that these assets will produce income over a number of years. In other words, the business did not purchase these assets with the intention to close operations soon after and then resell these assets.
The opposite view to this 'going concern' assumption is that the business will cease trading shortly and that all the assets will be sold off within the current year.
whether there are any factors that may put the company's status as a going concern in doubt.
Financial statements are prepared on the assumption that the entity is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations. This is one of the fundamental concepts of accounting. Different bases of measurement may be appropriate when the entity is not expected to continue in operation for the foreseeable future. Where a company is not a going concern, the break-up basis is used where all assets and liabilities are stated at Net Realizable Value
.
The company's auditor must consider whether the use of the going concern assumption is appropriate, and whether there are material uncertainties about the entity's ability to continue to operate as a going concern that need to be disclosed in the financial statements. An auditor considers such items as negative trends in operating results, loan defaults, and denial of trade credit from suppliers in deciding if there is a substantial going concern issue. An auditor who concludes that substantial doubt exists with regard to the appropriateness of the going concern assumption is required to issue an opinion reflecting this; a modified opinion if the company has appropriately disclosed the doubt and risks; and a qualified opinion if the company has not made appropriate disclosures. These are called "going concern" opinions.
Auditors can make two types of errors in such opinions - issuing a modified report for a company that remains viable and failing to issue a modified report for a company that becomes bankrupt before the next audit. Research has shown that only a small fraction of companies receiving modified reports become bankrupt, and that receiving such a report increases the likelihood that the company will change auditors. Through 2001, roughly half of companies that do become bankrupt had a modified opinion on their immediately prior financial statements, though this percentage has since risen higher. Auditors are at risk of being sued by financial statement users if a company that did not receive a modified opinion becomes bankrupt, although litigation reform in the 1990s lowered the risk of being sued and the liability if such a suit is successful.
s may take that as a sign of increased risk
, although an emphasis of matter
paragraph in an audit report does not necessarily indicate that a company is on the verge of insolvency. Despite this, some fund managers may be required to sell the stock
to maintain an appropriate level of risk in their portfolios. A negative judgment may also result in the breach of bank loan covenant
s or lead a debt rating firm to lower the rating on the company's debt, making the cost of existing debt increase and/or preventing the company from obtaining additional debt financing. Because of such responses to expressed concerns by auditors, in the 1970s, the American Institute of Certified Public Accountants
' Cohen commission concluded that an auditor's expression of uncertainty about the entity's ability to continue as a going concern "tends to be a self-fulfilling prophecy
. The auditor’s expression of uncertainty about the company’s ability to continue may contribute to making its failure a certainty."
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
that functions without the threat of liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
for the foreseeable future, usually regarded as at least within 12 months.
Definition of the 'going concern' concept
According to Peter Baskerville, http://knol.google.com/k/what-is-the-going-concern-concept-in-accounting# What is a 'going concern' in Accounting .The 'going concern' concept directs accountants to prepare financial statements on the assumption that the business is not about to go broke or be liquidated (i.e. where the business closes and sells all the assets for whatever price they can get).
So, unless there is significant evidence to the contrary, accountants will base their valuations and their reporting of financial data on the assumption that the business will remain in existence for an indefinite period.
An indefinite period means the foreseeable future or long enough for the business to meet its objectives and to fulfill its commitments. It is important to note that the 'going concern' concept does not imply or guarantee that the business is profitable and will remain so for the foreseeable future.
So, the 'going concern' concept assumes that the business will remain in existence long enough for all the assets of the business to be fully utilized. Utilized assets means obtaining the complete benefit from their earning potential. (i.e. if you recently purchased equipment costing $5,000 that had 5 years of productive/useful life, then under the going concern assumption, the accountant would only write off one year's value $1,000 (1/5th) this year, leaving $4,000 to be treated as a fixed asset with future economic value for the business). The 'going concern' concept supports the assumption that when a business buys assets like land, equipment, and buildings, it does so with the intent that these assets will produce income over a number of years. In other words, the business did not purchase these assets with the intention to close operations soon after and then resell these assets.
The opposite view to this 'going concern' assumption is that the business will cease trading shortly and that all the assets will be sold off within the current year.
Use in Accounting
In accounting, "going concern" refers to a company's ability to continue functioning as a business entity (concern being an early-20th century term for "business" or "enterprise"). It is the responsibility of the directors to assess whether the going concern assumption is appropriate when preparing the financial statements. A company is required to disclose in the notes to the Financial StatementsNotes to the Financial Statements
Notes to financial statements are additional notes and information added to the end of financial statements to supplement the reader with more information. Notes to financial statements help the computation of specific items in the financial statements as well as provide a more comprehensive...
whether there are any factors that may put the company's status as a going concern in doubt.
Financial statements are prepared on the assumption that the entity is a going concern, meaning it will continue in operation for the foreseeable future and will be able to realize assets and discharge liabilities in the normal course of operations. This is one of the fundamental concepts of accounting. Different bases of measurement may be appropriate when the entity is not expected to continue in operation for the foreseeable future. Where a company is not a going concern, the break-up basis is used where all assets and liabilities are stated at Net Realizable Value
Net realizable value
Net realizable value is a method of evaluating an asset's worth when held in inventory, in the field of accounting. NRV is part of the Generally Accepted Accounting Principles and International Financial Reporting Standards that apply to valuing inventory, so as to not overstate or understate the...
.
The company's auditor must consider whether the use of the going concern assumption is appropriate, and whether there are material uncertainties about the entity's ability to continue to operate as a going concern that need to be disclosed in the financial statements. An auditor considers such items as negative trends in operating results, loan defaults, and denial of trade credit from suppliers in deciding if there is a substantial going concern issue. An auditor who concludes that substantial doubt exists with regard to the appropriateness of the going concern assumption is required to issue an opinion reflecting this; a modified opinion if the company has appropriately disclosed the doubt and risks; and a qualified opinion if the company has not made appropriate disclosures. These are called "going concern" opinions.
Auditors can make two types of errors in such opinions - issuing a modified report for a company that remains viable and failing to issue a modified report for a company that becomes bankrupt before the next audit. Research has shown that only a small fraction of companies receiving modified reports become bankrupt, and that receiving such a report increases the likelihood that the company will change auditors. Through 2001, roughly half of companies that do become bankrupt had a modified opinion on their immediately prior financial statements, though this percentage has since risen higher. Auditors are at risk of being sued by financial statement users if a company that did not receive a modified opinion becomes bankrupt, although litigation reform in the 1990s lowered the risk of being sued and the liability if such a suit is successful.
Use in Risk Management
If a public company reports that its auditors have doubts about its ability to continue as a going concern, investorInvestor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s may take that as a sign of increased risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
, although an emphasis of matter
Emphasis of matter
Emphasis of matter is a type of paragraph in, or section of, an auditors' report on financial statements. Such a paragraph is added to indicate a significant uncertainty or other matter, which is disclosed appropriately in the notes forming part of the financial statements, but which the auditor...
paragraph in an audit report does not necessarily indicate that a company is on the verge of insolvency. Despite this, some fund managers may be required to sell the stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
to maintain an appropriate level of risk in their portfolios. A negative judgment may also result in the breach of bank loan covenant
Loan covenant
A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or which forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.Typically,...
s or lead a debt rating firm to lower the rating on the company's debt, making the cost of existing debt increase and/or preventing the company from obtaining additional debt financing. Because of such responses to expressed concerns by auditors, in the 1970s, the American Institute of Certified Public Accountants
American Institute of Certified Public Accountants
Founded in 1887, the American Institute of Certified Public Accountants is the national professional organization of Certified Public Accountants in the United States, with more than 370,000 CPA members in 128 countries in business and industry, public practice, government, education, student...
' Cohen commission concluded that an auditor's expression of uncertainty about the entity's ability to continue as a going concern "tends to be a self-fulfilling prophecy
Self-fulfilling prophecy
A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior. Although examples of such prophecies can be found in literature as far back as ancient Greece and...
. The auditor’s expression of uncertainty about the company’s ability to continue may contribute to making its failure a certainty."