For instance, the value of fixed assets (PP&E) is recorded at their original historical cost and depreciated over their useful life, i.e. the expected number of years in which the fixed asset will continue to contribute positive economic value. Under the going concern principle, the company is assumed to sustain operations, so the value of its assets (and capacity for value-creation) is expected to endure into the future. However, liquidating a company means laying off all of its employees, and if the company is viable, this can have negative ramifications not only for the laid-off workers but also for the investor who made the decision to liquidate a healthy company. Liquidating a going concern can give an investor a bad reputation among potential future takeover targets.
This means the business can pay all debt payments, fixed expenses, and operating expenses using its existing cash and a reasonable estimate of new cash flow during the year. New lenders will likely be reluctant to issue new credit, or any new credit issued will be prohibitively expensive. This credit crunch may trickle down to suppliers who may be unwilling to sell raw materials or inventory goods on credit.
How to determine going concern
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Going Concern Value vs. Liquidation Value: What is the Difference?
In general, an auditor examines a company’s financial statements to see if it can continue as a going concern for one year following the time of an audit. Conditions that lead to substantial doubt about a going concern include negative trends in operating results, continuous losses from one period to the next, loan defaults, lawsuits against a company, and denial of credit by suppliers. Accounting standards try to determine what a company should disclose on its financial statements if there are doubts about its ability to continue as a going concern.
- In the case there is substantial yet unreported doubt about the company’s continuance after the date of reporting (i.e. twelve months), then management has failed its fiduciary duty to its stakeholders and has violated its reporting requirements.
- Listing of long-term assets normally does not appear in a company’s quarterly statements or as a line item on balance sheets.
- Companies with low liquidity ratios, high employee turnover, or decreasing market share are more likely to not be a going concern.
- If a business is not a going concern, it means it’s gone bankrupt and its assets were liquidated.
- If a company’s liquidation value – how much its assets can be sold for and converted into cash – exceeds its going concern value, it’s in the best interests of its stakeholders for the company to proceed with the liquidation.
Use in risk management
Hence, a declaration of going concern means that the business has neither the intention nor the need to liquidate or to materially curtail the scale of its operations. 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. An entity is assumed to be a going concern in the absence of significant information to the contrary.
If the accountant believes that an entity consistency meaning 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. Going concern is important because it is a signal of trust about the longevity and future of a company. Without it, business would not offer nearly as much credit sales as suppliers, vendors, and other companies may not pay the company if there is little belief these companies will survive. In order for a company to be a going concern, it usually needs to be able to operate with a significant debt restructuring or massive financing overhaul.
Going concern value is a value that assumes the company will remain in business indefinitely and continue to be profitable. This differs from the value that would be realized if its assets were liquidated—the liquidation value—because an ongoing operation has the ability to continue to earn a profit, which contributes to its value. A company should always be considered a going concern unless there is a good reason to believe that it will be going out of business. The going concern principle is the assumption that an entity will remain in business for the foreseeable future.
Preparation of financial statements under this presumption is commonly referred to as the going concern basis of accounting. If and when an entity’s liquidation becomes imminent, financial statements are prepared under the liquidation basis of accounting (Financial Accounting Standards Board, 2014[1]). In accrual accounting, the financial statements are prepared under the going concern assumption, i.e. the company will remain operating into the foreseeable future, which is formally defined as the next twelve months at a bare minimum. Usually, liquidation value is applied when investors feel a company no longer has value as a going concern, and they want to know how much they can get by selling off the company’s tangible assets and such of its intangible assets as can be sold, such as IP. A company or investor that is acquiring a company may compare that company’s going-concern value to its liquidation value in order to decide whether it’s financially worthwhile to continue operating the company, or whether it is more profitable to liquidate it. Going concern is an accounting term used to identify whether a company is likely to survive the next year.
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The company will be required to write down the value of its assets if liquidation value is lower than the current value on the balance sheet. The write-down process includes taking a loss on the income statement, so net income already doing badly will get even worse. For private companies, outside investors may look to unload their shares to wash their hands of the company at any price possible, especially if there are legal problems. This will include a business valuation to attempt to value the company as a going concern and to value the assets at liquidation value. This may not actually hurt the stock price that much since auditors usually will only make a negative going concern determination when there have been problems for a while. 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.
Therefore, it may be noted that companies that are not a going concern may need external financing, restructuring, asset liquidation, or be acquired by a more profitable entity. Going concern is not officially included in the generally accepted accounting principles (GAAP) but some instruction is included in the generally accepted auditing standards (GAAS). Accountants who view a company as a going concern generally believe a firm uses its assets wisely and does not have to liquidate anything. Accountants may also employ going concern principles to determine how a company should proceed with any sales of assets, reduction of expenses, or shifts to other products. The valuation of companies in need of restructuring values a company as a collection of assets, which serves as the basis of the liquidation value. By contrast, the going concern assumption is the opposite of assuming liquidation, which is defined as the process when a company’s operations are activity based costing vs traditional steps results compared forced to a halt and its assets are sold to willing buyers for cash.
If management does have a plan to sell assets, seek additional financing, start selling a new gizmo, or raise money with new stock issuances, you’ll need to evaluate it. Auditors are required to be conservative, so it is certainly possible, although unlikely, that the plan will work. Management’s plan could include borrowing more money to kick the can down the road, selling assets or subsidiaries to raise cash, raising money through new capital contributions, or reducing or delaying planned expenses. In the first step, evaluate whether or not it is probable that the business will be able to meet all obligations during the next year.
Companies that are not a going concern may not have enough money to survive, and this fact must be publicly disclosed when an auditor audits their financial statements. A company may not be a going concern for a number of reasons, and management must disclose the reason why. The going-concern value of a company is typically much higher than its liquidation value because it includes intangible assets and customer loyalty as well as any potential for future returns. The liquidation value of a company will even be lower than the value of the company’s tangible assets, because the company may have to sell off its tangible assets at a discount—often, a deep discount—in order to liquidate them before ceasing operations. Examples of tangible assets that might be sold at a loss include equipment, unsold inventory, real estate, vehicles, patents, and other intellectual property (IP), furniture, and fixtures. The going concern presumption that an entity will be able to meet its obligations when they become due is foundational to financial reporting.
More specifically, companies are obligated to disclose the risks and potential events that could impede their ability to operate and cause them to undergo liquidation (i.e. be forced out of business). Under GAAP standards, companies are required to disclose material information that enables their viewers – in particular, its shareholders, lenders, etc. – to understand the true financial health of the company. The Going Concern Assumption is a fundamental principle in accrual accounting, stating that a company will remain operating into the foreseeable future rather than undergo a liquidation. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer. The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.
