‘Going concern’ accounting principle is an ongoing concern

Those who know about such things tell us that the presidential debates are less about issues than about the candidates’ values and the principles that guide their actions.

Debates are supposed to reveal these things, and to show us something about how candidates react to pressure. Most of us assume, and I think accurately, that pretty much anybody could be president on the days when there is nothing on the schedule but a Rose Garden reception and golf with a few governors. It is on the days when the agenda includes the unthinkable that presidents earn their salt and the lines in their faces.

There is a considerable distance between the intensity of these television debates and the quiet preparation of an auditor’s report, but they do have one thing in common: When things get tough, it is the fundamental principles that become important.

One of the fundamental principles of accounting involves the idea of the “going concern.” It is an accounting principle that makes infrequent appearances, but when it comes into play for a company… well, let’s just say that it is not a Rose Garden affair.

The going concern principle says that a firm’s financial position is evaluated under the assumption that the business is going to continue operating for the foreseeable future. If there is some question about whether the business can survive, then it could be necessary to move from standard accounting practice to something called liquidation accounting, a process that has some creepy similarities to an autopsy.

Compared with other accounting issues, the going concern principle doesn’t come up for discussion all that often. But there are some experts who believe that it should.

Elizabeth Venuti is one of those people. She is an assistant professor of accounting at Hofstra University, and says: “The going-concern principle is at the heart of accounting. It isn’t really possible to allocate costs, like depreciation for just one example, or differentiate between current and long-term debt if you think the company isn’t going to exist for long. And in today’s economy there are a lot of firms that are financially strapped, or experiencing market conditions that raise some degree of doubt about their survival.”

But despite the risks, auditors do not often raise going-concern doubts in their reports. In a recent article in The CPA Journal, Venuti writes that “approximately 40 percent to 50 percent of all companies filing for bankruptcy…failed to receive a going-concern paragraph in the audit opinion on their last financial statements issued prior to filing for bankruptcy.”

Venuti believes there is a mismatch between public expectations and the accounting profession as to the auditor’s responsibility to identify going-concern issues. And she believes that the two perceptions, public and professional, must be brought back into balance. A good start, in her view, would be to adopt a stronger auditing standard to guide accountants in how to treat financial issues that threaten a firm’s future.

The public tends to view an audited financial report as something resembling an annual physical checkup that produces, in most cases, a clean bill of health. But a medical checkup has limitations, and so does an audit. A significant number of people, for example, encounter life-threatening medical problems even though their recent physical checkup revealed nothing out of order.

But at least a medical exam deals with the present situation so, if no problems are detected, a physician has some hope of accurately forecasting continued good health. By contrast, an audit deals with the past – and in today’s economy, a forecast based on where a firm was three or six months ago is not risk-free.

Auditors and accountants, by both training and experience, are best equipped to examine a company’s past. Their work is important because all of our standards of financial performance – revenue, profitability, and return on investment – are calculated on the basis of things that have already happened.

But the skills that help to understand the past are not necessarily the best equipment when it comes to predicting the future – which is precisely what is involved in making a judgment about a company’s future. If analyzing the past were enough for success, most corporations would be run by accountants and historians.

Still, the public is going to insist that auditors make these judgments about a company’s future. Markets continue to impose considerable economic stress on firms, and management monkey business continues to position accounting at the center of doubt. As a result, there is a lot of pressure on the accounting profession to eliminate, or at least reduce, the risk of investing in business enterprises. Whether this works out the way we imagine it, though, remains to be seen.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101,” which appears monthly in The Snohomish County Business Journal.