The Going Concern Concept and the Auditor's Opinion Letter
Under Generally Accepted Accounting Principles (GAAP), both assets and liabilities are recorded and classified on the assumption that the company will continue to operate as a going concern for the foreseeable future. In other words, the going concern concept requires financial analyst to disregard the possibility that a company such as a customer or supplier will go bankrupt or be liquidated. Without the going concern assumption, most of the financial information creditors and other interested parties receive would be vastly different.
Assets are listed on the Balance Sheet at amounts that are significantly greater than their liquidation values with this assumption in mind. However, if there is a credible threat that a company will or may fail and go into bankruptcy or be liquidated, then auditors will drop this going concern assumption and their financial report will lists the value of assets at their liquidation value rather than at their acquisition cost minus accumulated depreciation.
A special type of audit comment that is particularly important to a credit professional relates to the ability of a customer to continue as a "going concern." A typical statement made by an outside auditor in their Auditor's Opinion Letter that creditors would be interested in reading is a "Going Concern" notice. A notice of this type will contain language such as this: "In light of the Company's recurring losses and negative cash flow, the auditors have substantial doubt about the Company's ability to continue as a "Going Concern."
Examples of problems that could cause the auditor to doubt the company's ability to remain in business include:
- Negative cash flow;
- Significant net losses;
- A serious decline in sales and in demand;
- Defaults on debts owed to secured creditors;
- Loan covenant violations;
- Sizable contingent liabilities;
- Lengthy strikes or work stoppages;
- Major product recalls;
- Tax liens placed on the business;
- Lawsuits filed against the company - in particular personal injury suits
If a substantial doubt exists about the company's ability to continue as a going concern for a period of one year from the balance sheet date, the auditors modify their report by adding a final paragraph indicating that:
- Assets were listed as though the company were a going concern, but in the event of a bankruptcy and liquidation, many of the company's assets would almost certainly not be worth as much in liquidation as the assets were to a going concern.
Edited by Michael C. Dennis.