The going concern assumption is the basic presumption, made when preparing financial statements, that a business will continue to operate for the foreseeable future and will not be forced to close down or sell off its assets. It allows accountants to record assets at cost and spread that cost over their useful lives, to classify assets and liabilities as current or long-term, and to defer some costs to future periods. If a business were expected to shut down soon, those treatments would make no sense, and assets would instead be reported at what they could fetch in a quick sale.
The assumption is one of the foundations of both US GAAP and IFRS. It is normally made silently: financial statements are prepared on a going concern basis unless management intends to liquidate the entity or has no realistic alternative. When serious doubts arise, however, the assumption becomes a matter for explicit assessment, disclosure and audit comment.
Management's assessment
Since ASU 2014-15, US GAAP (ASC 205-40) requires management itself, not just the auditor, to evaluate at each annual and interim reporting date whether conditions or events raise substantial doubt about the entity's ability to continue as a going concern within one year after the date the statements are issued. Substantial doubt exists when it is probable that the entity will be unable to meet its obligations as they fall due within that period. Under IFRS, IAS 1 requires management to consider at least twelve months from the end of the reporting period.
Warning signs that commonly trigger the assessment include:
- Recurring operating losses and negative operating cash flow.
- Working capital deficiencies, low liquidity ratios and an inability to pay suppliers on time.
- Defaults on loan agreements or breaches of covenants, especially without a covenant waiver.
- Large debts maturing soon with no clear refinancing.
- Loss of a major customer, licence or key supplier, or significant legal or regulatory action.
Disclosure and mitigation
If substantial doubt exists, management considers whether its plans, such as raising new equity, selling assets, cutting costs or a debt restructuring, are probable of being carried out and of alleviating the doubt. If the plans resolve the doubt, the company discloses the conditions and how the plans address them. If they do not, it must state clearly in the notes that substantial doubt exists. For example, a retailer with $12 million of loans due in nine months, $1.5 million of cash and continuing losses, whose lender has refused to extend the loans, would likely need to make that statement unless it had firm commitments for new funding.
The auditor's role
Auditors must evaluate management's assessment independently, under AU-C 570 for private entities and AS 2415 for public companies overseen by the PCAOB. If the independent auditor concludes that substantial doubt remains, the auditor's report includes a separate paragraph or section headed along the lines of "Substantial Doubt About the Company's Ability to Continue as a Going Concern." This is often called a going concern opinion or qualification, although the overall opinion can still be unmodified if the disclosures are adequate. A going concern paragraph can itself worsen a company's position, since lenders and suppliers may tighten terms after seeing it, which is why auditors weigh it carefully.
When the assumption no longer holds
When liquidation becomes imminent, US GAAP (ASC 205-30) requires the entity to switch to the liquidation basis of accounting. Assets are then measured at the amount of cash expected from their sale, and liabilities at the amounts expected to settle them, including costs of winding up. The book value of specialized equipment or intangible assets can fall sharply under this basis, since such items may have little value in a forced liquidation.
The going concern assumption is closely linked to insolvency, but the two are not the same: a company can face substantial doubt without being legally insolvent, and a formal bankruptcy filing such as a Chapter 11 reorganization does not automatically mean the going concern basis is abandoned, since the business may continue trading. Analysts treat going concern disclosures as one of the most serious warning signals in a set of accounts.