What is the Going Concern Assumption?
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.
What Does Going Concern Mean?
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.
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.
If a company is a “going concern,” then it’ll be capable of the following:
- Meet Required Financial Obligations – e.g. Interest Expense, Principal Amortization on Debt
- Continue to Generate Revenue from Core Operations – i.e. Day-to-Day Business Activities
- Fulfill Non-Financial, Working Capital Payments – e.g. Accounts Payable (A/P), Accrued Expenses
What is the Going Concern Principle in Accounting?
The going concern principle is a fundamental accrual accounting principle that assumes a company will continue operating indefinitely for the foreseeable future.
The reason the going concern assumption bears such importance in financial reporting is that it validates the use of historical cost accounting.
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.
In the absence of the going concern assumption, companies would be required to recognize asset values under the implicit assumption of impending liquidation.
The formal definition of the term “going concern” per GAAP / FASB can be found below.
FASB Going Concern Disclosure Requirements (Source: FASB)
Even if the company’s future is questionable and its status as a going concern appears to be in question – e.g. there are potential catalysts that could raise significant concerns – the company’s financials should still be prepared on a going concern basis.
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.
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).
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.
How to Mitigate the Going Concern Risk?
At the end of the day, awareness of the risks that place the company’s future into doubt must be shared in financial reports with an objective explanation of management’s evaluation of the severity of the circumstances surrounding the company.
In effect, equity shareholders and other relevant parties can then make well-informed decisions on the best course of action to take with all material information on hand.
Often, management will be incentivized to downplay the risks and focus on its plans to mitigate the conditional events – which is understandable given their duties to uphold the valuation (i.e. share price) of the company – yet the facts must still be disclosed.
The management team of a company at risk of liquidation can come up with and announce plans with actions such as:
- Divesting Non-Core Assets to Fulfill Mandatory Debt Principal Repayments or Service Interest Expenses
- Cost-Cutting Initiatives to Improve Profitability and Liquidity
- Receiving New Equity Contributions from Existing Stakeholders
- Raising New Capital via Debt or Equity Issuances
- Restructuring Debt with Lenders to Avoid In-Court Bankruptcy (e.g. Extend Repayment Date, Change from Cash to PIK Interest)
Going Concern Value vs. Liquidation Value: What is the Difference?
In the context of corporate valuation, companies can be valued on either a going concern basis or a liquidation basis.
- Going Concern-Basis → Continue Operating into the Foreseeable Future
- Liquidation-Basis → Operations are Expected to Cease with the Liquidation of Assets to Distribute to Creditors
The going concern assumption – i.e. the company will remain in existence indefinitely – comes with broad implications on corporate valuation, as one might reasonably expect.
How Does the Going Concern Approach Impact Valuation?
The going concern approach utilizes the standard intrinsic and relative valuation approaches, with the shared assumption that the company (or companies) will be operating perpetually.
- Intrinsic Value (DCF) → The expectation of continued cash flow generation from the assets belonging to a company is inherent to the discounted cash flow (DCF) model. In particular, around three-quarters (~75%) of the total implied value from a DCF model can typically be attributable to the terminal value, which assumes the company will remain growing at a perpetual rate into the far future.
- Relative Valuation (Comps) → The relative valuation methods, such as comparable company analysis and precedent transactions, estimate the value of companies based on the pricing of comparable companies by the market. However, a sizeable portion of investors in the market utilize DCF models or at least take the fundamentals of the company into consideration (e.g. free cash flows, profit margins), so comps take into account these factors, too – just indirectly as opposed to explicitly.
What is the Liquidation Valuation Method? (Fire Sale)
By contrast, the going concern assumption is the opposite of assuming liquidation, which is defined as the process when a company’s operations are forced to a halt and its assets are sold to willing buyers for cash.
If the liquidation value is calculated, the context of the valuation is most likely either:
- Restructuring → The analysis of a company currently or in the midst of succumbing to financial distress (i.e. declaring bankruptcy).
- Collateral Analysis →A worst-case scenario analysis conducted by lenders or related third parties.
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.
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.