What Is Going Concern?

What Is Going Concern? | Accounting Smarts
Charles Hall

Last updated by

Charles Hall

on

June 10, 2022

The term "Going Concern'' is well known in the accounting sector but only recently made its way into the common vernacular of many business owners today.

The term "Going Concern'' is well known in the accounting sector but only recently made its way into the common vernacular of many business owners today.

With the unprecedented spread of Covid-19 in 2020, many companies began re-evaluating their own viability, adapting and changing to meet their business needs, and continue to function effectively under unusual and unfamiliar conditions.

'Going concern' is an accounting term used to describe a business condition. If a company is a going concern, it's been identified to have sufficient resources to continue functioning viably for at least one year, even in the event of unusual circumstances that may affect performance.

The term "going concern" is used when a company is audited and their business practices and financial circumstances are scrutinized and evaluated to determine long-term viability. While this is standard practice for routinely audited companies, recently, with the covid-19 pandemic, many organizations have requested or completed going concern audits to help secure their viability.

ShowHide

Table of contents

What is Going Concern?

Ideally, when a company is audited, whether it is a yearly event, or if a specifically requested going concern audit is conducted, the company will be deemed viable for the upcoming year and able to withstand potential negative conditions. There are several components of a business that are reviewed in this type of audit:        

  • Sales - Whether a company provides services, education, or goods, an auditor will review accounts receivable and compare that amount to the cost of running the business, including expenses such as rent, utilities, supplies, payroll, and other ongoing expenses
  • Employees - Auditors will review the size of the staff, payroll, any labor difficulties, staff turnover, cost of training new employees, etc.
  • Record-Keeping - Accounting procedures, sales tracking, invoices, and other records are reviewed for accuracy and proper handling
  • Legal Issues - If a company has any pending lawsuits or other legal issues, auditors will review the case(s) and estimate the viability of the lawsuits and any costs that may be incurred by the company if they experience negative judgments in any legal proceedings.
  • Intellectual Property - Auditors will review any intellectual property, patents, trademarks, logos, and protected processes and procedures and attempt to assign value to each item.
  • Business Relationships - Auditors will review the relationships between the company and their suppliers and customers and determine if the relationships are solid and in the business entity's best interest.
  • Financing - Auditors will review any open loans and will review current terms, determine if any loans are in default, and estimate the impact of the current loan payments on the business as a whole.
  • Desktop Procedures - The auditors will review the business procedures that are in place and determine if the company's processes are streamlined for maximum efficiency and flexibility.

Once the audit is completed, the auditor will make a determination regarding the business and their cash flow, desktop procedures, and overall sales numbers and decide if the business has enough in the way of cushion or business assets to function properly over the next 12-18 months. They will also determine the business's viability in the event of a calamity that can affect business, whether that be a natural disaster or otherwise, such as the Covid-19 pandemic.

If a company does not meet the requirements of going concern, they must disclose this to their shareholders, and the facts and conditions must be accurately depicted within the company's financial statements. Not meeting the standard of going concern can create a variety of issues for a company, including decreasing stock value and lowering consumer confidence.

Why Include Going Concern Assumption in an Audit

For larger corporations, or publicly traded companies that answer to a Board of Directors and Shareholders, a going concern assumption is often part of the yearly audit process. Going concern audits help shareholders estimate stock values and help them to make decisions regarding their stock options. As such, many publicly owned companies require a going concern audit to give shareholders a clear picture of a company's overall financial health.

However, with the Covid-19 pandemic, even companies that are not subject to yearly audits, or going concerns status, have found value in completing this type of audit. By taking a closer look at the organization's overall health and determining what weaknesses exist, even smaller companies can benefit by identifying areas of concern within the business and developing continuity plans or corrective action programs to increase the health of the organization.

What are Red Flags in a Going Concern Audit?

Several clear red flags can appear in a going concern audit that will require an organization to create a corrective action plan to improve the company's overall performance. Some examples of red flags include:      

  • Capital Deficit
  • Denial of credit
  • Disposal of significant assets
  • History of defaults on loans or debt restructuring
  • Lawsuits
  • Loss of a key patent
  • Loss of a key supplier or customer
  • Work stoppages

These situations or circumstances taken alone do not automatically indicate a problem with a business. In fact, there are often very good reasons why a company may experience one or more of these "negative" signs.

However, when businesses function in these states for long periods, or this becomes the company's status quo, there may be cause for concern. Taking a closer look at each individual item can help clarify when and if there is a cause for concern.

Capital Deficit

Business experts suggest that a viable business should have at least 3-6 months, but preferably up to a full year of cash reserve available to cover the company's business expenses at any given time. While the business may never be closed for an extended period, having that cash on hand is one indicator of a company's overall health. If a company lacks a significant buffer or their liabilities exceed their assets, they are said to have a capital deficit.

There are times where a capital deficit is a temporary, almost expected situation. For example, a small business start-up may operate for quite a while with a deficit in the beginning. Also, if a company grows quickly and needs to expand significantly to meet its customers' needs, it may operate with a deficit for a period of time. However, when a company regularly operates without a significant financial buffer for a long time as their status quo, the capital deficit is cause for concern.

Loan Defaults and Credit Restructuring

Defaulting on a business loan is never ideal, but there are circumstances where even a viable, well-run business may run into trouble. Any new business carries a degree of risk and defaults often happen during the first 12-36 months that an up-and-coming business is in existence. Many businesses will do some debt restructuring to avoid defaulting on loans.

Loan restructuring is often a solution for a business experiencing temporary financial difficulty and, in fact, may be necessary to get a company back on track. However, if a company is continually moving debt from one bank to another, taking out loans to cover established loans, and restructuring their credit to obtain immediate cash on hand, that is an indicator of serious financial problems.

Lawsuits

Many companies, especially if they have been in business for a long time, have experienced lawsuits. It could be a disgruntled ex-employee who felt they were treated unfairly, a customer unhappy with products or service, or a supplier who believes the company is not meeting their contract terms. Just because a company is named in a lawsuit, it doesn't mean they are a bad risk.

However, lawsuits cost money, even when a company has been found not at fault. Lawsuits can be a red flag for a variety of reasons. Too many lawsuits may be an indicator of poor business practices, and negative judgments can cost a company quite a bit of money to rectify.

Additionally, a company's reputation can be seriously damaged by litigation, even if they are found to be not at fault. If a company has multiple suits or multiple judgments against them, it can be a sign of poor business practices and an indicator of instability and lack of longevity.

Denial of Credit

Denial of credit can be particularly problematic. During the first 12-24 months of existence, start-up costs to get a business up and running can be quite high, and oftentimes, the business is operating in the red. Having fixed capital such as money in the bank, equipment, products to sell, etc., is vital, so businesses often take on a good deal of debt during the first few years. As such, they may also be turned down quite a bit by banks as simply too high-risk.

A huge red flag and a clear indicator that a business is not financially sound could be if a company has a history of being denied credit, whether due to slow payments, loan defaults, a high-risk business, or having too much outstanding debt already. While any business can have temporary cash flow issues, with good relationships with banks and other lenders, they can often get:

  • Loans restructured
  • Additional cash
  • A deferred payment or two

However, if creditors refuse to work with a company due to past negative financial behavior, a denial of credit could be the first nail in the business's coffin.

Work Stoppages

Many businesses have certain times of year that are considered the "busy" season and other months that are particularly slow. Seasonal businesses may depend on income during the three busy months of their tourist season to carry them through and pay full expenses for the entire year.

Common seasonal businesses are:

  • Campsites
  • Construction
  • Ice cream
  • Ski resorts
  • Surf and gift shops

These businesses may employ full staff for part of the year and run with a skeleton crew at other times. Some may close their doors entirely during off-seasons.

Even year-round businesses may have reasonable work stoppages for financial or staffing reasons. Additionally, some manufacturing companies may schedule production runs strategically, with a shut down during off-months to save money.

As long as customer and client needs are being met, stoppages aren't always a concern. However, multiple unplanned stoppages or worker strikes, and continual slow periods, can also signify serious financial issues for a business.

Disposal of Assets

Disposal of assets is when a company removes a long term asset from its financial books. This is done when the asset, for example, equipment or machinery, has depreciated significantly in value, is being sold, or should no longer be listed as a company asset.

This is done for both tax and insurance purposes and to accurately record the proceeds from the sale of the item in the books. It is a routine procedure for many businesses and often occurs when a business is purchasing new equipment.

However, this can represent a red flag if, during an audit, it is found that the equipment or machinery is still being used or has not been sold, as is suggested by the disposal of assets. Additionally, if a company seems to perform multiple disposals of assets that are inconsistent with industry standards, for example, a laundromat writing off washing machines every five years, where industry standards are typically 10 years, they may be attempting to avoid paying taxes or misrepresenting the value of their business.

Loss of a Key Supplier or Customer

Most businesses can sustain the loss of a supplier or the loss of customers. It is expected, after all, that with competition, customers will come and go. In terms of suppliers, businesses typically have a variety of suppliers to choose from to satisfy their needs, and suppliers will often offer enticing price breaks or better credit terms to gain new business. Therefore, a loss on either side, customer or supplier, may not be significant

However, it can be a significant issue when a company's business relies on a customer for a large percentage of their income. For example, an airplane manufacturer loses a government contract for building airplanes for the Air Force. A loss of that size can be catastrophic.

Additionally, the loss of a supplier that provides a significant percentage of materials that may be hard to find elsewhere, or are being provided at a large discount, can also create a significant issue for a company.

Loss of a Key Patent

In the US, patents protect companies for a period of time when they manufacture or create a unique design or product. Typically a design patent can last 14 years and a utility patent for 20 years. Once a patent expires, competitors can begin using the original design, recipe, or process to create their comparable product.

The end of a protected patent period results in an increase in competition in the marketplace and usually a significant price drop for the item in question.

The expiration of a patent is not a surprise. Most companies will try to adjust their sales mix in the years before the expiration is due so the loss won't be catastrophic. However, when a company depends too much on one patented item for the bulk of its income, this loss can be the beginning of that organization's end.

If a company cannot afford to lower its consumer prices to compete with other manufacturers, it may lose a large percentage of its income through patent expiration.

Should All Businesses Be Audited for Going Concern?

Auditing is a complex business. Some organizations are required to submit to yearly audits, others every 3-5 years, and for some businesses, especially privately-owned organizations, official audits are not required at all. A going concern audit does not have to be a part of a formal audit process. However, even small companies can benefit from completing an audit, either internally or using an outside contractor.

With the Covid-19 crisis in 2020, many businesses were unprepared for the dramatic loss of income that occurred with mandatory quarantines and shutdowns. As such, many business owners are now trying to identify any weaknesses within their business and fiscal operations and make the necessary changes to ensure they can survive a significant income loss.

Having an Accounting team review every aspect of the business for going concern can mean the difference between shutdown and success.

Making Necessary Changes

Even without completing a full auditing process, 2020 brought to light how important it is for businesses to be prepared for the unexpected. Ideally, a business that is in a position of strength can operate successfully and remain viable throughout a catastrophe event. While a going concern audit process isn't required for many organizations, the audit principles are of vital importance.

Therefore, it makes sense for any business, large or small, to look at their processes and financial circumstances with a critical eye, identify areas of concern, and make any necessary changes to strengthen their overall financial position. Rather than wait for the time when disaster hits, companies should make the tough financial decisions now. Adjusting operational processes, staffing, and addressing any financial concerns today will help ensure that the business remains successful tomorrow and in the years to come.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall