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"Going concern" is an accounting term used to describe a business that is expected to operate for the foreseeable future or at least the next 12 months. It assumes that the business can generate income, meet its obligations and doesn’t plan or won’t need to liquidate in the coming year.
The going concern concept is a key assumption under generally accepted accounting principles, or GAAP. It can determine how financial statements are prepared, influence the stock price of a publicly traded company and affect whether a business can be approved for a loan.
How is going concern determined?
It is the responsibility of the business owner or leadership team to determine whether the business is able to continue in the foreseeable future. If it’s determined that the business is stable, financial statements are prepared using the going concern basis of accounting. This allows some prepaid expenses to be deferred until a later date.
What is the role of a financial auditor?
A financial auditor is hired by a business to evaluate whether its assessment of going concern is accurate. After conducting a thorough review (audit) of the business’s financials, the auditor will provide a report with their assessment.
An unqualified opinion is a positive outcome. It’s given when an auditor has no concerns about the financial statements of a business or its ability to operate in the future. Lenders, creditors and investors all want to see this type of result.
A qualified opinion, on the other hand, is not what a business wants to see. It's given when the auditor has doubts about the company and the assumption that it is a going concern. A qualified opinion can be a concern to investors, lenders and other stakeholders.
Mitigation of a qualified opinion
Before an auditor issues a going concern qualification, company leadership will be given an opportunity to create a plan to take corrective actions that can improve the outlook for the business. If the auditor determines the plan can be executed and mitigates concerns about the business, then a qualified opinion will not be issued.
These plans may include:
Selling assets to repay debt or cover operating expenses.
Cutting expenses to save cash and improve profitability.
Receiving additional equity contributions from owners or shareholders.
Getting additional financing, if possible, or restructuring debt to avoid liquidating the company.
What are some going concern red flags?
No single factor spells imminent doom for a business, but there are red flags that can signal trouble.
Here are some situations that could be of concern:
Low current ratio: A current ratio (current assets to current liabilities) that is less than 1 could indicate that a business doesn’t have enough cash and other easily liquidated assets (assets easily converted to cash) available to pay its short-term liabilities.
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.
Loss of employees: The departure of key personnel who can't be easily replaced may place a burden on the business.
Legal issues: Existing or potential lawsuits, regulatory issues and other legal matters could result in financial burdens the business would need to overcome.
Declining market share: A company facing stiff competition in the market and decreased demand for its products may have an uncertain future.
Disclosure of a going concern qualification
When an auditor issues a going concern qualification, the way their opinion is disclosed depends on the structure of the business.
The auditor is required by the Securities and Exchange Commission to disclose in the financial statements of a publicly traded company whether going concern status is in doubt. This can protect investors from continuing to risk their money on a business that may not be viable for much longer.
If there’s significant evidence that a privately held business might not be viable under the going concern assumption, the auditor must disclose it in the audit report. 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.
How a going concern qualification affects a business
A business could face the following challenges when receiving a negative audit:
Declining investment: A qualified opinion might lead investors to avoid a company or even sell their shares in the company.
Valuation request: Investors or other shareholders might ask for a business valuation to determine the true value of a business before making a final decision about how to act in light of the negative opinion.
Credit challenges: Lenders look at a company's financial statements to assess creditworthiness and would be reluctant to loan money to a business that is not stable.
Liquidation accounting: If it appears the business will have to cease operations, the accountant might have to “write-down” the value of the business’s inventory or other assets, which reduces the overall value of the company.
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A version of this article was first published on Fundera, a subsidiary of NerdWallet.