The going concern principle is the assumption that an entity will remain in business for the foreseeable future. Conversely, this means the entity will not be forced to halt operations and liquidate its assets in the near term at what may be very low fire-sale prices. By making this assumption, the accountant is justified in deferring the recognition of certain expenses until a later period, when the entity will presumably still be in business and using its assets in the most effective manner possible.
An entity is assumed to be a going concern in the absence of significant information to the contrary. An example of such contrary information is an entity’s inability to meet its obligations as they come due without substantial asset sales or debt restructurings. If such were not the case, an entity would essentially be acquiring assets with the intention of closing its operations and reselling the assets to another party.
If the accountant believes that an entity may no longer be a going concern, then this brings up the issue of whether its assets are impaired, which may call for the write-down of their carrying amount to their liquidation value. 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.
The going concern concept is not clearly defined anywhere in generally accepted accounting principles, and so is subject to a considerable amount of interpretation regarding when an entity should report it. 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 auditor evaluates an entity’s ability to continue as a going concern for a period not greater than one year following the date of the financial statements being audited. The auditor considers (among other issues) the following items in deciding if there is a substantial doubt about an entity’s ability to continue as a going concern:
- Negative trends in operating results, such as a series of losses
- Loan defaults by the company
- Denial of trade credit to the company by its suppliers
- Uneconomical long-term commitments to which the company is subjected
- Legal proceedings against the company
If there is an issue, the audit firm must qualify its the audit report with a statement about the problem.
It is possible for a company to mitigate an auditor's view of its going concern status by having a third party guarantee the debts of the business or agree to provide additional funds as needed. By doing so, the auditor is reasonably assured that the business will remain functional during the one-year period stipulated by GAAS.