Going Concern Assumption in Accounting

In accounting, going concern refers to a business that is expected to continue operating for the foreseeable future, typically at least the next 12 months. This assumption is fundamental to the preparation of financial statements and has implications for various aspects of a company’s operations and financial reporting.

Financial Statements

When a business is considered a going concern, its financial statements are prepared using the going concern basis of accounting. This allows for the deferral of certain prepaid expenses until a later date. For instance, rent paid in advance can be recorded as a prepaid expense and amortized over the lease term. Similarly, insurance premiums paid upfront can be deferred and recognized as an expense over the policy period.

Role of a Financial Auditor

A financial auditor is hired to evaluate whether a business’s assessment of going concern is accurate. They provide an opinion on the company’s ability to operate in the future. An unqualified opinion indicates that the auditor has no concerns about the company’s financial statements or its ability to continue as a going concern. Conversely, a qualified opinion expresses doubts about the company’s ability to continue as a going concern. In such cases, the auditor may require the company to provide additional information or take corrective actions to mitigate the concerns raised.

Going Concern Red Flags

There are several red flags that may indicate a business is not a going concern. These include:

• Low current ratio: A current ratio below 1 indicates that a company may not have enough liquid assets to meet its short-term obligations.
• Inability to obtain a loan: If a business is unable to secure financing from lenders, it may raise concerns about its creditworthiness and ability to continue operating.
• Loss of key personnel: The departure of key employees or management can disrupt operations and raise questions about the company’s ability to maintain its competitive position.
• Legal issues: Ongoing lawsuits, regulatory investigations, or other legal matters can have a significant financial impact and jeopardize a company’s ability to continue as a going concern.
• Declining market share: A company facing stiff competition and decreasing demand for its products or services may struggle to generate sufficient revenue to sustain its operations.

Disclosure of Going Concern Qualification

If an auditor issues a going concern qualification, it must be disclosed in the financial statements. Publicly traded companies are required by the Securities and Exchange Commission (SEC) to disclose going concern status in their financial statements. Privately held businesses should also disclose going concern qualifications in their audit reports.

Impact on Business

A negative audit opinion as a going concern can have several adverse consequences for a business. It may lead to:

• Declining investment: Investors may be hesitant to invest in a company with a going concern qualification, leading to a decline in its stock price and reduced access to capital.
• Credit challenges: Lenders may be reluctant to provide loans to a company with a going concern qualification, making it difficult for the company to obtain financing.
• Liquidation accounting: In severe cases, a company may be forced to liquidate its assets if it is unable to continue operating as a going concern. This involves selling off assets to repay creditors and wind down operations.

Conclusion

The going concern assumption is a critical principle in accounting that affects the preparation of financial statements and has implications for various aspects of a company’s operations and financial reporting. A financial auditor’s assessment of going concern is crucial in providing assurance to stakeholders about the company’s ability to continue operating in the foreseeable future. Red flags that indicate a business may not be a going concern should be carefully monitored and addressed to mitigate risks and ensure the long-term viability of the company.

References

• https://corporatefinanceinstitute.com/resources/accounting/going-concern/
• https://www.nerdwallet.com/article/small-business/what-is-the-going-concern-assumption
• https://www.investopedia.com/terms/g/goingconcern.asp

FAQs

What is the going concern assumption?

The going concern assumption is a fundamental principle in accounting that assumes a business will continue to operate for the foreseeable future, typically at least the next 12 months. This assumption is crucial for the preparation of financial statements and has implications for various aspects of a company’s operations and financial reporting.

How does the going concern assumption affect financial statements?

When a business is considered a going concern, its financial statements are prepared using the going concern basis of accounting. This allows for the deferral of certain prepaid expenses until a later date and the recognition of assets and liabilities based on their expected future benefits and obligations.

What is the role of a financial auditor in assessing going concern?

A financial auditor is responsible for evaluating whether a business’s assessment of going concern is accurate. They conduct a thorough review of the company’s financial statements, operations, and other relevant information to determine if there are any material uncertainties that may cast doubt on the company’s ability to continue as a going concern.

What are some red flags that may indicate a business is not a going concern?

Several red flags may indicate a business is not a going concern, including a low current ratio, inability to obtain a loan, loss of key personnel, legal issues, and declining market share. These red flags should be carefully monitored and addressed to mitigate risks and ensure the long-term viability of the company.

What is a going concern qualification, and how does it affect a business?

A going concern qualification is an opinion expressed by an auditor when they have substantial doubt about a company’s ability to continue as a going concern. This qualification must be disclosed in the company’s financial statements and can have several adverse consequences, such as declining investment, credit challenges, and the need for liquidation accounting.

What is the importance of the going concern assumption in accounting?

The going concern assumption is important because it provides a basis for the preparation of financial statements that are relevant and useful to users. It allows accountants to record assets and liabilities at their historical cost and defer certain expenses until they are incurred. Without the going concern assumption, financial statements would need to be prepared on a liquidation basis, which would result in a significantly different presentation of the company’s financial position and performance.

How can a company address going concern issues?

A company can address going concern issues by taking steps to improve its financial position and reduce uncertainties. This may involve actions such as restructuring debt, reducing expenses, increasing sales, or obtaining additional financing. The company should also work closely with its auditor to provide any necessary information and explanations to support the going concern assumption.

What are the implications of a negative going concern opinion?

A negative going concern opinion issued by an auditor can have several implications for a company. It may lead to a decline in investor confidence, difficulty in obtaining financing, and increased scrutiny from regulators. The company may also face legal challenges and potential liability if it is unable to continue as a going concern.