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The Going Concern Principle:
when and how to assess the value of a company and/or its assets
The going concern concept is one of the cornerstones of the financial accounting world. In essence, the going concern says that a Balance Sheet of a company must reflect the value of that company as if it were to remain in existence for and beyond the foreseeable future. The opposite of the going concern concept, so to speak, is to say that the company will fold within one year from the Balance Sheet date.
We will see in this article that the going concern concept is vital for us to be able to take as much of a rational view of a company as is possible. In this article, we will discuss the following key questions: who makes the going concern assessment and why?; and how do we arrive at the liquidation value of a company and/or its assets?.
There are two major parties in the assessment of a company as a going concern: the company’s management and its auditors. In addition, given that the following factors may lead to a going concern reassessment, the list of who makes a going concern assessment could possibly include a major creditor; a financier/banker. Those factors are:
(Edwards)
International Accounting Standard 1 (revised 1997), "Presentation of Financial Statements" sets out management's responsibility for assessing going concern as follows:
"When preparing financial statements, management should make an assessment of an enterprise's ability to continue as a going concern. Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do so. When management is aware … of material uncertainties … which may cast significant doubt upon the enterprise's ability to continue as a going concern, those uncertainties should be disclosed. When the financial statements are not prepared on a going concern basis, that fact should be disclosed, together with the basis on which the financial statements are prepared and the reason why the enterprise is not considered to be a going concern.
In assessing whether the going concern assumption is appropriate, management takes into account all available information for the foreseeable future, which should be at least, but is not limited to, twelve months from the balance sheet date.”
(IAS 1)
IFAC, in their International Standard on Auditing (ISA) exposure draft on the Going Concern principle, laid out a comprehensive view of it. They discuss the role both of the management of the company and its auditors. Firstly, management:
Management's assessment of the going concern assumption involves making a judgment, at a particular point in time, about the future outcome of events or conditions which are inherently uncertain. The following factors are relevant:
And now the auditor’s responsibility. In general, the IFAC position is conservative: there is no doubt that they allow for the auditor to have a key role in the assessment of a company from a going concern perspective. However, they take the now traditional view that the auditor need not be a bloodhound, searching through every nook and cranny in an attempt to get to the bottom of whether the going concern principle is valid or not. Moreover, the simple fact that the auditor did not say that the company should no longer be considered a going concern, does not mean that it is!
The
auditor's responsibility is to consider whether there is material uncertainty
related to events or conditions which may cast significant doubt upon the
entity's ability to continue as a going concern based on the auditor's
knowledge of relevant events or conditions at the time of conducting the audit.
The auditor's consideration of the going concern assumption applies
irrespective of the accounting framework that has been used in the preparation
of the financial statements, even if the going concern assumption is not
specifically mentioned within that framework. The auditor cannot predict future
events or conditions which may cause an entity to cease to continue as a going
concern. Accordingly, the absence of any reference to going concern uncertainty
in an auditor's report cannot be viewed as a guarantee as to the entity's
ability to continue as a going concern. Management's assessment of the entity's
ability to continue as a going concern is a key part of the auditor's
consideration of the going concern assumption.
The auditor
considers the going concern assumption for the same period for which management
assumes responsibility, a period which should be at least, but is not limited
to, twelve months from the balance sheet date.
Nevertheless, IFAC more positively, in my view, go on to discuss the audit plan. In this discussion, they don’t exactly contradict the extract above in which we take the bloodhound point of view, but they do clearly set out that the auditor does have a duty to take a feedforward view of his role: anticipate that there may be a problem, at least
In developing the audit plan … The auditor considers events and conditions relating to the going concern assumption at the planning stage of the audit, because this consideration allows for more timely discussions with management, review of management's plans and resolution of any identified going concern issues and thus may affect the nature, extent and timing of the auditor's procedures. ... In addition, the auditor remains alert to events or conditions relating to the going concern assumption that come to the auditor's attention throughout the audit since these may further affect the procedures to be performed.
Some of the key issues that IFAC sets out as events that the auditor ought to consider in this context are financial, adverse key financial ratios, operating and other. As perhaps we should expect, the events listed by IFAC are comprehensive, even though they say their list is not exhaustive. Let’s look at each of these four categories in turn.
IFAC discuss the position in which fixed term borrowings are approaching maturity but the company may have no realistic prospects of renewal or repayment. Alternatively, there could be evidence of over trading and an excessive reliance on short term borrowings to finance long-term assets.
The auditor must also look for indications of withdrawal of financial support and negative cash flows as shown either by the historical accounting records and/or by cash budgets or projections.
Clearly, anything prescribed under this heading could be dangerous, misleading, or simply not comprehensive enough. That is, depending on the state of the Economy in which the company is operating, the nature of the sector in which the company is operating and so on, the number and variability of ratios could differ from case to case.
Nevertheless, the IFAC view here is a sensible one; and they discuss, inter alia ,
Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
Arrears or discontinuance of dividends no longer being declared; and the possibility that the latest declared dividends have yet to be paid, well after their due date. A persistent rescheduling of creditors’ payments and maybe the shift from buying on account to buying for cash would ordinarily be cause for concern. The need to reschedule formal loans would also be a cause for raised eyebrows in the context of the going concern principle.
Companies that find that they are unable to secure financing for essential new product development or other essential investments must clearly have pause for thought at least as to the view of others of their long term viability.
The development of such cost and management accounting approaches as Activity Based Costing and the Balanced Scorecard to the work of organisations should lead us to applaud the inclusion in this discussion of this section: Operating aspects. In that financial and financial management are learning more each day about the impact and importance of the non financial aspects of businesses. IFAC discuss the operating aspects of a business in the following terms:
Other
Under the heading of Other, IFAC adds a few other aspects that are pointers to the kind of issues that the auditor needs to look out for in the context of the going concern debate. These remaining issues are:
Of course, whilst each of these issues, either singly or collectively, could be considered serious for any company, taken in isolation, we could take a mistaken view of the situation. For example, even though a company might be having to reschedule its creditor and debt repayments; management could be taking steps to reorganise its affairs in such a way that it resolves its financing situation within the forthcoming financial year.
Finally in this section, we should make the observation that a company may receive a going concern clean bill of health; and yet a material uncertainty exists. That is, we need to consider whether the financial statements of a company adequately describe the principal conditions that give rise to a significant doubt about the entity's ability to continue in operation for the foreseeable future and management's plans to deal with these events or conditions; and state clearly that there is a material uncertainty related to events or conditions which may cast significant doubt about the entity's ability to continue as a going concern and, therefore, that it may be unable to realize its assets and discharge its liabilities in the normal course of business.
(This section is based on the work of Braun: see reference section at the end for details)
“A valuation
is always determined as of a particular point in time, and generally should not
be relied upon for other dates."
(Braun)
There are a variety of valuation approaches a business appraiser will consider in the valuation of a … company. Among the most common are the
In actual practice, a combination of approaches is commonly used with differing weights given to each selected approach as appropriate.
The asset approach relies on a company's adjusted book value by substituting the fair market value of assets and liabilities for the stated value of assets and liabilities. This approach is most useful for valuing a company which has significantly undervalued assets. It may also be useful for valuing a company with substantial non-operating assets such as land or natural resources. This approach is generally not used, however, to value a company as a going concern .
The market approach is simple for the quoted company: just take the stock market value of the company at the relevant date and multiply it by the number of shares in issue. However, what about the private company that is not quoted on any stock exchange, and whose shares are thus very difficult to value. The solution here requires trying to find one or more public companies that are as similar as possible to the private company being valued. To use this approach, we must compare the private company to the public companies in terms of size, growth, gearing and so on to determine relative risk.
The discounted cash flow approach relies on multiple year projections based on management's reasonable estimates of the company's prospects. The reasonableness of projections should be considered by comparison to the company's historical results and the outlook for the company and the industry.
Projected cash flow is determined by depreciation to earnings to depreciation and subtracting capital expenditures plus or minus changes in working capital. A terminal value at the end of the projection period is then calculated. The appropriate discount rate may be the company’s own hurdle rate or it based on the company's weighted average cost of capital . A risk premium may be added to the discount rate as appropriate under the circumstances to determine a risk-adjusted discount rate: despite the very sophisticated methods of deriving discount rates, it is still common for management to add a fudge factor to cover for risk.
The formula approach, or rules of thumb, may be considered if appropriate. A formula may take many forms, such as a multiple of book value or a multiple of revenues. The advantage of using a formula approach is that it is simple and inexpensive to use. However, the disadvantage is that it may not reflect fair market value. Furthermore, a formula may not be dynamic enough to reflect changing market conditions in which a company is operating.
Any of these approaches will need to be further adjusted to account for qualitative factors and special circumstances such as non-recurring gains and losses,
reasonable management compensation, key person risk, "excess" cash, and non-operating assets.
Determining the value of a business is one of the most difficult aspects of any transaction, since every business is unique.
A common misconception is that valuation is an exact science. While the use of formulas in a valuation implies exactness, it is very difficult to set the worth of a company at a single figure. To establish a fair market value,
hard figures, such as assets, liabilities, and historical earnings and cash flow are used.
soft , or subjective, figures, such as projected earnings, future cash flow, and the value of intangibles (e.g., patents, know-how, the quality of management, and leases at below-market rates) are also used. Soft figures also include such considerations as current market conditions, industry popularity, and, most important, the objectives of the seller or buyer.
With all this subjectivity, fair market value can be, at best, only a range of estimates.
The final selling price can be either higher or lower than the estimated range of values for the company, depending on the
and so on
In fact, the selling price of a company sometimes does not seem to have much relation to its estimated value. Moreover, ask appraisers the value of your business and they will respond, "What's the purpose of the valuation?": to sell it as a going concern, to sell it on a liquidation basis, to sell it on a break up basis. Different techniques can be used to arrive at different values, and each of the values may be correct for a specific situation. For purposes of this discussion, we are assuming that we are valuing a business based on the valuation techniques used for buying or selling a company as a going concern.
Whichever technique is used, the valuation comprises these key elements:
We have already seen some of what Deloitte and Touche have to say about valuing a business above; but their section on recasting, or adjusting, financial statements is new and interesting; and some of their ideas follow. We should bear in mind, however, that if we tried to apply these ideas in anything other than a considered and serious manner, we would have severe difficulties.
Adjustments to the Income Statement can include:
Some typical Balance Sheet adjustments may include the following:
After identifying and quantifying applicable adjustments, you will have a more meaningful set of financial statements to use to make financial projections and to compare the company's performance with that of other companies.
The going concern principle is among the most important accounting, and therefore business, principles. Nevertheless, despite the definition of the principle being relatively straightforward, the application of it can be fraught with difficulties. At one extreme, we have many examples of companies that were given a clean going concern bill of health at the end of one financial year only to find itself in liquidation within 12 months of the end of that financial year. At the other extreme, we have the significant difficulties in trying to arrive at a fair value for a company that seems properly assessed as a failing company.
This article has discussed the role of management, auditors and others in the going concern assessment of a company and we have explored several of the issues facing someone who is trying to place a value on a business: for either going concern or non going concern purposes.
The International Federation Of Accountants
International Standard on Auditing
Exposure Draft: Going Concern (1997)
From: //www.ifac.org/StandardsAndGuidance/ExposureDrafts/IAPC/GoingConcern/Body.html#8
International Accounting Standard 1 (revised 1997) Presentation of Financial Statements
International Accounting Standards Committee
Edwards, Donald E.
Going-concern evaluation: factors affecting decisions
From: http://www.nysscpa.org/cpajournal/old/14522928.htm
Richard S. Braun (1998)
Valuing A Private Company: An Introduction to Business Valuation
Willamette Capital Willamette Management Associates
From: http://www.fed.org/leading_companies/jan98/tips.html
Deloitte & Touche LLP
VALUING THE BUSINESS
From: http://www.dtonline.com/selling/valuingbusiness.htm
© Duncan Williamson
