Accounting Essentials: Evaluation of Going Concern for Business Viability
What is Going Concern?
The "going concern" principle is a fundamental concept in accounting that assumes a company will continue its operations into the foreseeable future without the need or intent to sell its assets or significant downsizing operations. This principle is crucial as it forms the basis of how financial statements are prepared, influencing the recording of transactions and the valuation of assets and liabilities. If a company is not considered a going concern, the value of its assets might need to be adjusted to reflect their liquidation value, which can significantly alter its financial statements.
Requirements for assessing going concern
According to the International Financial Reporting Standards (IFRS) and IFRS for SMEs, accountants must evaluate and disclose any significant uncertainties that could affect an entity's ability to continue as a going concern. Similarly, Section 29 of the Companies Act requires that financial statements fairly represent the financial status and performance of the company. Failing to properly assess going concern risks could mislead stakeholders and result in legal or reputational damage to both the accountant and the company. It is vital for accountants to thoroughly assess all relevant factors to ensure financial statements accurately reflect the company's situation in accordance with IFRS and applicable local laws.
How to Evaluate Going Concern
Professional judgment is essential when deciding if a going concern assumption is appropriate. The results of calculations should be weighed against the overall business context to decide on the best way to disclose them in the financial reports.
Step 1: Gather Relevant Information
Collect financial statements, forecasts, cash flow projections, details on current economic and industry conditions, debt repayment schedules, financial covenants, and notes from board meetings that discuss financial viability.
Consider plans for future operations such as new funding, restructuring, or asset disposals.
Step 2: Analyse Financial Indicators
Examine financial indicators that might reveal signs of potential trouble. Key areas to focus on include:
Liquidity Ratios: Short-term financial health can be gauged through ratios like current ratio or quick ratio. Liquidity ratios are critical for assessing a company's ability to meet its short-term obligations. Key ratios to consider include:
Current Ratio: Divide current assets by current liabilities. A ratio above 1 indicates that the company has more assets than liabilities due within the next year, suggesting adequate short-term financial health. A ratio under 1 may signal potential liquidity problems.
Quick Ratio (Acid Test): Calculate this by subtracting inventory from current assets and then dividing by current liabilities. This ratio provides a more stringent test of liquidity by excluding inventory, which is not always readily convertible to cash.
Profitability Trends: Declining profits or continued losses might indicate sustainability issues. Analysing profitability trends helps in understanding the entity's ability to generate earnings relative to its sales, total assets, and equity, which is crucial for long-term sustainability:
Trend Analysis: Review the trends in key profitability metrics such as gross profit margin, operating margin, and net profit margin over several periods. Consistent declines may indicate deteriorating operational efficiency or increasing costs that could threaten the entity's viability.
Year-over-Year Comparisons: Compare the current year's financial performance with that of previous years to identify any patterns of declining profitability.
Cash Flow Issues: Negative cash flows from operating activities are a red flag. Cash flow from operating activities is a fundamental indicator of a company’s health, as it shows the cash that is being generated by the company's core business operations:
Operating Cash Flow: Positive cash flow from operations is a good indicator that the company is generating sufficient revenue to maintain business operations. Negative operating cash flow, especially if sustained over multiple periods, is a major concern as it suggests the company might not be able to sustain its operations without additional financing.
Cash Burn Rate Analysis: For startups or growth companies, calculate the rate at which the company is spending its cash reserves and compare this to its cash inflows. High burn rates can quickly deplete cash reserves, leading to financial distress.
Debt Levels: High debt levels or breaches of debt agreements may suggest financial distress. High levels of debt can impose significant financial strain on a company, particularly if it faces challenges in generating enough cash flow to meet its debt obligations:
Debt-to-Equity Ratio: This ratio compares the company's total liabilities to its shareholder equity. A high debt-to-equity ratio indicates that the company is primarily financed through debt, which can be risky if not supported by stable cash flows.
Interest Coverage Ratio: This is calculated by dividing earnings before interest and taxes (EBIT) by interest expenses. A low ratio suggests that the company may have difficulty covering interest payments, which could lead to solvency issues.
Compliance with Loan Agreements: Review loan agreements for any covenants imposed by lenders and assess the company's compliance with these covenants. Breaches of covenants can lead to renegotiation of loan terms or demand for immediate repayment, both of which could precipitate a liquidity crisis.
Step 3: Consider External Factors
External factors such as market downturns, regulatory changes, or loss of a major customer can also affect an entity’s ability to continue as a going concern. Accountants should evaluate the broader environment in which the entity operates.
Step 4: Review Management’s Plans
Understand and critically evaluate management's plans to mitigate negative conditions or events. Plans could include raising new capital, renegotiating debt terms, or other strategic actions like mergers or acquisitions.
Step 5: Prepare Financial Projections
Using the gathered information and analysis, prepare or review forward-looking financial projections that consider various scenarios. These should realistically assess the entity’s ability to meet its obligations as they come due.
Step 6: Assess and Document
Based on the information and analysis, make a judgment about the entity's ability to continue as a going concern for at least twelve months from the date the financial statements are issued. Document all assumptions, supporting evidence, and conclusions reached during the going concern assessment.
Accounting under going concern
The going concern principle ensures financial statements are made under the assumption that the business will keep running and not be forced to stop and liquidate its assets. It's foundational to many accounting practices like how revenues and expenses are handled.
Revenue and Expense Deferral
Companies that are going concern can spread the recognition of some expenses and revenues over future periods that better reflect their actual economic impact. This includes things like spreading out the cost of prepaid expenses or recognising revenue from long-term projects as they progress.
Depreciation and Amortisation
Depreciation and amortisation spread the cost of an asset over its expected life, matching the asset’s cost with the revenues it helps generate. If a company didn’t operate under the going concern assumption, it would have to adjust asset values to what they could be sold for immediately, rather than their value over time.
Example: XYZ Corporation
Scenario: Going Concern
XYZ Corporation operates with the assumption it will continue its business indefinitely. Under this assumption, XYZ is preparing its year-end financial statements:
Fixed Assets: XYZ has purchased equipment valued at R100,000, expected to last 10 years. The equipment is depreciated at R10,000 annually, reflecting its use over a decade.
Inventory: Inventory is recorded at the cost to purchase or produce it, assuming it will be sold in the normal course of business.
Long-term Liabilities: Loans on the balance sheet are listed as long-term liabilities, assuming that the company will continue to service its debt over the agreed period.
Scenario: Not a Going Concern
In the non-going concern scenario, the primary concern shifts to liquidation and settling debts. Asset valuations are reduced to their immediate, recoverable amounts, and liabilities are prioritised for quick settlement. This scenario typically results in a more conservative presentation on the balance sheet, emphasising current, realisable values and urgent liabilities.
In the scenerio above if due to severe financial difficulties, XYZ Corporation is expected to liquidate within the next year the year-end financial statements reflect a different approach:
Fixed Assets: The same equipment must now be valued at its current market value or liquidation value, which might only be R60,000 if sold quickly in distress. The focus shifts from depreciation to immediate recoverable value.
Inventory: Inventory is valued not at historical cost but rather at net realisable value, which is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
Long-term Liabilities: Loans may need to be reclassified as current liabilities because they will likely need to be settled sooner than originally planned due to the liquidation.
This example highlights how the assumption of going concern (or the lack thereof) fundamentally alters a business's financial reporting and outlook, impacting stakeholders' decisions based on the financial health and longevity of the company.
Communicating to Management and Auditors
If there are concerns about the entity’s ability to continue as a going concern, these should be communicated to the management and those charged with governance. If the concerns are significant, it may be necessary to disclose these in the financial statements, along with management’s plans and mitigating factors. Clear communication with management and auditors helps ensure that everyone involved understands the situation and can respond appropriately.
Revisit Regularly
Going concern assessments are not a one-time task. Conditions can change, and new information can emerge, so it’s crucial to revisit the assessment regularly and update it as necessary.
Learn all you need to know about preparing financial statements with CIBA’s Accountant in Practice Subscription
What you will learn
Subscribing to the Accountant-in-Practice series provides you access to monthly webinars covering ethics, financials, reporting, audit and assurance, working papers, law, technology, management topics, and enable you to:
Be aware of the latest legislative changes and what it means for your business, practice, and your clients;
Prepare compliant financial statements fast;
Issue reliable reports on financial statements;
Understand the laws and regulations that govern your profession; and
Develop enhanced business advisory skills.
