The going concern principle is one of the key assumptions under generally accepted accounting principles (GAAP) — and whether or not a business is a going concern is of greater interest to the general public now than it was a decade ago.
But what does it really mean for a business to be a going concern? What is the going concern assumption? And how does the going concern assumption apply to your business? Here’s everything you need to know about this important accounting principle.
What is the going concern assumption?
The going concern assumption seems simple enough on the surface. Under the going concern assumption, a business is expected to stay in business indefinitely, or at least for the foreseeable future.
Doesn’t that describe all businesses, though? There aren’t very many business owners who plan to only stay in business for a short time. In that regard, aren’t all businesses going concerns?
Well, there is more to the going concern assumption than the business owner’s plans for the business. If the going concern assumption were based only on intentions, nearly every business would be a going concern. So let’s dig deeper to define this accounting principle.
Intent has very little to do with the going concern assumption. To determine whether a business is, in fact, a going concern, an accountant — typically an external auditor — must dig deeper into the business’s financial statements.
External auditors, explained
It’s important to understand that for the rest of this article, the term “auditor” refers to an accountant who has been hired to conduct a comprehensive review (audit) of the business’s financials and submit a report of their findings. This professional is significantly different from an IRS or other compliance auditor.
Many businesses undergo an independent, external audit on an annual or some other recurring basis in order to make sure their financial statements accurately represent the financial position of the business. The term “audit” need not cause alarm… it’s a routine part of business for many companies.
When is a business no longer a going concern?
A business is considered to be a going concern until there is significant evidence to the contrary. Specifically, an analysis of the business’s financial statements must show there is a threat of the business becoming unable to fulfill its financial obligations within the next 12 months in order for a business to no longer be a going concern. An auditor renders a “negative going concern opinion” in such cases.
There are a number of warning signs that could point to a business no longer being a going concern:
An alarmingly low current ratio: The current ratio is the relationship between a business’s current assets and current liabilities. A current ratio of less than 1 indicates a business doesn’t have enough cash and other easily liquidated assets (assets that can be converted to cash) available to pay its short-term liabilities.
Excessively past due accounts payable: Most businesses will have past due accounts payable from time to time. But if a large amount of the business’s accounts payable balance is past due or if the past due amounts exceed 90 days, it could indicate the business is becoming insolvent.
Inability to get a loan: A business’s inability to obtain further financing indicates lenders have low confidence in the business’s ability to repay the obligation. This can be a warning sign the business may not be a going concern, at least not for much longer.
Dependence on discounted sales to make ends meet: Most businesses will discount their products or services from time to time. In and of itself, this is not a concern. However, when a business starts relying heavily on discounted sales, it can be a warning sign of trouble.
These are just a few warning signs which might alarm an auditor. No one sign spells imminent doom for a business, but when combined — either with each other or with other factors — it can spell trouble for the business as a going concern.
What does a negative going concern opinion mean?
First of all, this doesn’t mean the business is definitely going to fold. A negative going concern opinion simply means the auditor suspects the business will have to close for financial reasons within the next 12 months.
The auditor’s opinion is disclosed in the annual report for the company, or it is included in his audit report. If a business is a publicly traded company, the Securities and Exchange Commission (SEC) requires the auditor to disclose on the financial statements if a business’s going concern status is in doubt. This is done to protect investors from continuing to risk their money on a business which may not be viable for much longer.
Privately held companies might also choose to voluntarily undergo an external audit. Sometimes this is done at the request of a board of directors, and other times it is done to reassure the business owner that the accounting is sound. If the auditor finds significant evidence that the business might not be viable under the going concern assumption, he must disclose that in his audit report. And, even if the business’s financials aren’t audited, an accountant who has concerns about the business’s viability should disclose those concerns to the business owner.
Even if the auditor issues a negative going concern opinion, it doesn’t mean the business will definitely fail. The business’s management team’s interpretation of the business’s position, as well as any plans they are making to ensure the business remains a going concern, must also be taken into consideration. These plans may include:
Selling assets to pay for debt or operating expenses
Cutting expenses to improve the cash and profitability position of the company
Additional contributions of equity by owners or shareholders
Taking out additional financing (if that is an option) or restructuring debt to avoid liquidating the company.
How a negative going concern opinion affects business
If the business has investors, a negative going concern opinion might lead those investors to sell their shares in the company. Investors or other shareholders might also call for a business valuation to determine the business’s true value before making a final decision about how to act in light of the negative opinion.
If it appears the business will have no choice but to cease operations, the accountant might have to “write-down” the value of the business’s inventory or other assets which will have to be sold when the business closes. Writing down the value of these assets — which are then known as impaired assets — reduces the overall value of the company and shows the value of the assets at their liquidation value. Liquidation value is always lower than the value of the assets on the balance sheet of a going concern.
How the going concern assumption applies to your business
Chances are, your business isn’t publicly traded or subject to routine external audits as part of its bylaws. You might be wondering how the going concern principle applies to your business, or if you even need to be aware of it.
Just because your business isn’t subject to regulatory reporting requirements or bylaws upheld by a board of directors doesn’t mean the going concern assumption doesn’t apply to you. The going concern assumption can also give you insight on how potential lenders or investors are viewing your business’s financial statements. Being aware of this GAAP assumption and how it applies to your business will help you assess your business’s overall health and viability from a higher level.
A version of this article was first published on Fundera, a subsidiary of NerdWallet