What Is Going Concern Assumption?

The going concern assumption is an accounting principle that assumes an entity will remain in business for the foreseeable future. It allows the deferral of certain expenses to be taken at a later period.

This assumption is generally accepted unless there is significant information that suggests otherwise, such as an inability to meet obligations without significant asset sales or debt restructurings.

The going concern assumption also allows for the recognition of certain assets and liabilities that would not be recognized under different assumptions.

This helps to ensure the accuracy of financial statements and allows investors to make better decisions about the entity’s future.

Consequences of a Negative Going Concern Opinion

Receiving a negative opinion from an auditor in regards to the going concern assumption can trigger an alarm for investors. This is because the auditor’s opinion on the company’s ability to continue its operations may indicate that the entity is in financial distress. In such a situation, the business may need to seek outside sources of funding in order to keep operations going.

Alternatively, if the entity decides to discontinue operations, investors may incur substantial losses.

Furthermore, a negative going concern opinion could lead to a decrease in the company’s value. Business valuation is a process used to determine the actual worth of a company and the going concern asset-based approach is a commonly used method. If the auditor’s opinion is negative, the company’s assets may be valued at a lower rate than expected, resulting in a decrease in the overall value of the company.

In addition, creditors may be reluctant to provide the company with any financing due to the negative opinion. This could limit the ability of the company to access the necessary resources to continue its operations, leading to a further decrease in the value of the company. Therefore, it is important that investors pay careful attention to the auditor’s opinion on the going concern assumption.

Going Concern Evaluation Items

Auditors evaluate a range of factors to assess an entity’s ability to remain a viable business over the next year. The going concern assumption is a critical element of the audit process, as it informs the auditor’s opinion on the financial statements. To make a determination, auditors must consider various factors, both qualitative and quantitative.

The qualitative factors include the entity’s history and management team, as well as their reputation in the market, while the quantitative factors focus on the entity’s financial performance. Negative trends in operating results, such as consecutive losses, loan defaults, denial of trade credit, uneconomical long-term commitments, and legal proceedings against the company are all taken into consideration when evaluating the going concern assumption.

The following table provides a summary of the various factors that auditors use to evaluate the going concern assumption:

When assessing the going concern assumption, auditors must weigh the various factors and determine if there is significant doubt about the entity’s ability to continue as a going concern over the next year.

Example

Considering the limitations imposed by the federal government on the production, export, import, sale, and marketing of Chemical X, auditors must consider the implications of the restrictions when evaluating the entity’s ability to remain a viable business.

If Chemical X is the only product produced, the business cannot be classified as a going concern.

However, if a company is facing serious financial problems and is unable to cover its duties, but receives a bailout package and credit guarantees from the government, it can still be deemed a going concern despite its weak financial standing.

Auditors should also evaluate the company’s ability to generate enough cash flow to remain viable and the potential for future profitability, as it can provide evidence of the company’s going concern status.

Alternative: Break-up basis of accounting

The break-up basis of accounting is an alternative option that may be used in certain jurisdictions to assess the company’s assets in relation to its liabilities. This approach is different than the traditional going concern assumption, which aims to assess the company’s financial performance over a period of time. The main purpose of the break-up basis of accounting is to determine if the company has enough assets to cover liabilities.

If the company has enough assets to cover liabilities, then any remaining assets can be distributed to shareholders. The format of the financial statements remains the same, regardless of the basis of accounting used. The only difference is the focus of the financial statements, which is on assessing the company’s assets and liabilities, rather than their performance over a period of time.

Therefore, the break-up basis of accounting is an alternative approach for assessing a company’s assets and liabilities, and can be used instead of the traditional going concern assumption in certain jurisdictions. This method can be used to determine if the company has enough assets to cover liabilities, and if so, any remaining assets can be distributed to shareholders.

Auditor Concern over negative opinion

In light of the potential consequences associated with issuing a negative going concern opinion, auditors must consider the implications of their decisions. As such, auditors may be hesitant to issue a negative going concern opinion because of the potential repercussions that could arise as a result.

This is due to concerns that such an opinion could become a self-fulfilling prophecy, leading to lower stockholders’ and creditors’ confidence in the company and subsequent credit rating downgrades. This could make it difficult for the company to obtain new capital and increase the cost of existing capital.

The threat of a negative going concern opinion may also be a factor in the decision-making process. This is because the auditor’s independence can be compromised by the management’s control over the tenure and remuneration of the auditor. This could lead to management engaging in ‘opinion shopping’ to find a more favorable opinion. Auditors must be aware of these potential conflicts and take appropriate measures to ensure their independence.

Auditors must take into account the potential implications of issuing a negative going concern opinion and the potential conflicts of interest when making their decision. It is essential that they remain independent and impartial when making such an important decision, and that management does not attempt to influence the opinion.

Conclusion

The going concern assumption is fundamental to the accrual method of accounting and generally accepted accounting principles. It affects the recognition of assets, liabilities, revenues, and expenses.

A negative going concern opinion may result in the inability to obtain financing, the potential for business closure, and a decreased market valuation.

Auditors must be careful to properly assess the going concern status of a company and consider all relevant factors.

When the going concern assumption is not valid, the alternative break-up basis of accounting should be applied in order to provide a more realistic picture of the company’s financial position.