Going Concern: The Assumption Under a Balance Sheet

The going concern assumption is the belief that a business will keep trading for the foreseeable future, and it sits under every figure on a balance sheet. Stock is measured at what it will fetch in normal trade, and a machine at cost less wear rather than at a hurried buyer's price. Withdraw the assumption and the same assets are measured for a forced sale, so the figures collapse without anything being sold.

A balance sheet is not a price list. Every figure on it is a measurement made under an assumption about what happens next, and that assumption is almost never printed on the face of the sheet. Anjani Stationers, an invented printer of school notebooks and exercise books working one small printing unit in one city, carries its printing machine at Rs 21,00,000. The carrying figure is what the machine cost less the wear already charged against profits. The machine is worth Rs 21,00,000 to a business that will print exercise books on it for seven more years. The same machine is worth a great deal less to somebody who has to find a buyer for a second-hand printing machine by the end of next month. Which of those two numbers belongs in the accounts depends entirely on which future is assumed.

Consider an ordinary kitchen. The idea is exactly the same size there. Asked to put a figure on the fridge, the owner would say something close to what was paid, less a few years of use. The expectation is to keep using it. Asked the same question on the morning of a move to another city in ten days, the honest answer collapses. Now the figure has to be whatever somebody will hand over this week for a used fridge with no warranty and no time to shop around. Nothing about the fridge changed. The assumption about the next ten days did. A balance sheet behaves in precisely that way, on a much larger scale, and the assumption doing the work is called going concern.

What does the going concern assumption actually assume?

Going concern assumes one thing and only one thing: that the business will keep operating for the foreseeable future, and in particular that it will not be forced to shut down or to sell off large parts of itself at short notice. Read that twice. Most of the confusion around the phrase comes from reading more into it than it says.

The going concern assumption is about continuing to trade, and it is not an assumption about profit, growth, health or safety. Losing money and stopping are different events, so a business can lose money for three years running and still be a going concern. Growth eats cash, and cash is what keeps the doors open, so a business can be growing fast, winning customers and still fail the test. The question is never whether this is a good business. The question is whether this business will still be trading, or whether it is going to be wound up or forced into a fire sale. Everything else is a separate conversation.

An assumption that narrow is also easy to walk straight past. Going concern is not a line on the balance sheet with a number beside it. The assumption lives in the basis of preparationThe short statement at the front of a set of accounts saying which rules the figures were built under and which assumptions were made in building them., a short statement at the front of a set of accounts saying which rules and which assumptions the figures were built under. In almost every set of accounts the basis of preparation says the same unremarkable thing, so most readers skip it. The one year it says something different is the year it matters more than every number behind it.

Why does every figure on a balance sheet depend on it?

Take Anjani Stationers' balance sheet at 31 March of year one and walk down it line by line, asking of each number what it would have to be if the business were stopping instead of continuing. Cash is Rs 7,00,000, and that answer does not move: money is money. Money owed by schools stands at Rs 75,00,000, and that figure assumes the schools go on paying a supplier they still need next term. Stock stands at Rs 22,00,000, and that assumes the exercise books reach the schools that ordered them. Insurance paid in advance stands at Rs 2,00,000, and that assumes there is a business left to insure for the remaining six months. The van at Rs 6,00,000 and the machine at Rs 21,00,000 both assume years of further use. Total assets Rs 1,33,00,000, liabilities Rs 21,00,000, equity Rs 1,12,00,000.

Every measured figure on the sheet except cash rests on the going concern assumption. Withdrawing the assumption therefore moves all of them at once rather than one of them a little. Everything moving at once is the shape worth carrying away. The assumption is not one more item sitting beside the others; it is the floor they are all standing on. Pull the floor and nothing stays where it was.

An assumption underneath every line makes the sheet an odd document. The sheet looks like a list of things and amounts, and a list of things and amounts invites reading as a price list. A balance sheet is nothing of the kind. Each figure is a measurement, each measurement is conditional, and the condition is written somewhere else in words. The gap between how a balance sheet looks and what it is doing is the source of most of the trouble that follows.

What changes when the assumption no longer holds?

Move to year two. The Sunrise Public School group, the largest single block of Anjani Stationers' customers, stops paying altogether. Nothing in the previous year's dealings announced it: the group had bought on ordinary sixty to ninety day terms like every other school, settled its bills, and placed its usual order. The group simply stopped. Anjani Kulkarni, who signs the cheques, now has to face a question he has never had to ask about his own business, and the accountant Meera Rao has to answer it in writing before the next set of accounts can be prepared at all.

Suppose the answer comes back that the business cannot keep trading. Then the accounts are prepared on a break-up basisPreparing a set of accounts for a business that is stopping rather than continuing, so each item is measured at what it would raise on being sold off rather than at what it is worth in use. instead. Every item is then measured at what it would realise on being disposed of rather than at what it is worth in continued use. Here is the whole sheet under three different futures, and the middle column matters because reality rarely offers the two clean extremes.

The recovery figures in the second and third columns are assumptions. Any asset's price on a closure depends on who is left to buy it and how quickly it has to go, so the same table for a different business would carry different rates. The arithmetic is not an assumption: Rs 7,00,000 plus Rs 40,00,000 plus Rs 4,00,000 plus Rs 3,00,000 plus Rs 6,00,000 is Rs 60,00,000, and Rs 60,00,000 less Rs 21,00,000 is Rs 39,00,000.

Now put the two totals beside each other. The second picture is the one that changes how people read accounts. Assets fall from Rs 1,33,00,000 to Rs 60,00,000, a drop of Rs 73,00,000. The debts do not move at all: the paper supplier is still owed Rs 18,00,000 and the staff are still owed Rs 3,00,000, Rs 21,00,000 either way. Because liabilities are fixed and assets are not, the entire Rs 73,00,000 fall lands on equity. Equity drops from Rs 1,12,00,000 to Rs 39,00,000 without a single item being sold or a single transaction taking place.

Why do the printed exercise books fall furthest?

The steepest line in the table behaves that way for a particular reason, and the reason is not a rule about stock in general. Anjani Stationers' Rs 22,00,000 of stock is not a warehouse of blank paper. Around Rs 16,00,000 of it is finished exercise books already printed with individual school crests: the Sunrise Public School group's crest on the cover, the school's name on the spine, its house colours on the ruled margin. Crested books are worth full value to exactly one buyer in the city and close to nothing to anybody else. The remaining Rs 6,00,000 or so is plain paper, board and ink that anybody in the trade can use.

An asset's fall on a break-up basis is decided by how many buyers exist for it once the intended buyer is gone. The crested books have one buyer, so they collapse. The plain paper has many buyers, so it does not. At the assumed recovery rates, the crested books raise about Rs 1,60,000 as waste paper, roughly ten paise in the rupee, and the plain stock raises about Rs 2,40,000, roughly forty paise. Together that is the Rs 4,00,000 in the table.

The pattern is a familiar one, usually met without being named. A wedding caterer holds four hundred printed menu cards with two names and a date on them; the day the wedding is called off they are worth the paper. A tailor holds a rack of half-finished uniforms in one school's colours. A sign painter holds a board already lettered with one shop's name. In every case the value in the accounts is real while the buyer exists and evaporates when the buyer walks away. The evaporation is not a fault in the accounts. The accounts are doing exactly what they were built to do, under the assumption they were built on.

What makes someone doubt the assumption in the first place?

Doubt does not arrive as an announcement. Doubt accumulates in figures that were already sitting in the accounts, and the clearest way to see it is in the figures Anjani Stationers actually had rather than in a general list of warning signs. Three things are visible. Cash of Rs 7,00,000 against Rs 21,00,000 falling due to a supplier and to staff, so what is owed is three times what is in the bank. Rs 78,00,000 due from schools before the provision, more than half of everything the business holds, sitting with a handful of names rather than hundreds. And a business that made Rs 38,00,000 of profit in the year while its cash went down by Rs 1,00,000, so the profit is sitting in other people's hands.

The signs that raise a going concern question are almost always concentrationHow much of a business's sales, or of the money owed to it, sits with one customer or a small handful of them rather than being spread across many. and timing rather than losses, and both were on Anjani Stationers' sheet a full year before the Sunrise Public School group stopped paying. Signs on the sheet a year early do not mean Anjani Kulkarni made an obvious mistake. Every business supplying schools in one city has concentrated customers. Concentration is what the trade looks like, and the alternative was not a safer set of customers, it was fewer customers. And trade creditThe arrangement under which a supplier hands over goods now and is paid weeks or months later, standard in most business to business trade. of sixty to ninety days is the term schools buy on, not a term he chose. The signs describe a shape of risk, not a fault.

Who decides, and over what period?

The people who prepare the accounts decide. At Anjani Stationers that means Anjani Kulkarni and Meera Rao between them, working out whether the business can keep trading, and writing the answer down before a single figure is measured. The two of them are not guessing about the whole future. The question put to them covers a defined period running forward from the accounts, and within that period they have to look at what is due, what is likely to come in, what the bank has committed and what could reasonably be sold or renegotiated.

The period is not left to the preparer to choose. A defined forward period is set by the accounting standards, along with the wording required where the doubt is real but the business is still expected to continue, and both are read from the material the Institute of Chartered Accountants of India (ICAI) publishes. A number of months written from memory is exactly the kind of figure that should never reach a set of accounts, so the discipline is to name the source and go and read it.

Three outcomes are possible, and only the third one changes the measurement basis. If the judgement is that the business continues and there is no real doubt, the accounts are prepared on the going concern basis and nothing is said. If the business is expected to continue but there is material uncertaintyA doubt large enough that a reader of the accounts would want to be told about it before drawing any conclusion from the figures. about it, the accounts are still prepared on the going concern basis, and the doubt is stated in the notes so that a reader knows the figures rest on a belief somebody is not sure of. Only if the judgement is that the business cannot continue does the whole sheet move to a break-up basis. The middle outcome is the one most people miss: disclosed doubt does not re-measure anything.

Why is stating the doubt out loud so hard?

The uncomfortable part is who reads the statement. A statement of material uncertainty about a business continuing is read by the people whose behaviour decides whether the business continues. The paper supplier reads it and asks for payment in advance instead of thirty days. The bank reads it and reviews the limit. The schools read it and place next term's order with somebody who will still be printing in June. Each of those responses is entirely reasonable on its own, and together they can turn a doubt into an outcome.

The disclosure can contribute to the very result it describes, and it must still be made. A reader who is not told is a reader being misled about what every figure on the sheet depends on. Disclosure is the honest resolution, and two comfortable escapes from it are worth resisting. The first escape is to pretend there is no such effect. Anyone who has watched a supplier tighten terms knows there is. The second escape is to conclude that disclosure should therefore be softened. Softening hands the cost of the doubt to whoever reads the accounts last and knows least. Between an uncomfortable disclosure and a misleading silence, the accounts are built to choose the disclosure every time.

How do a lender, an analyst and a household read accounts with this in mind?

A lender reads the assumption before it reads the numbers. Anjani Stationers' bank does not lend against Rs 1,33,00,000 of assets. The bank asks what those assets would raise if it ever had to rely on them, and that is a break-up question by construction. The break-up question is why a bank will lend a high proportion against money owed by customers and a low proportion against printed stock, and why the printing machine, carried at Rs 21,00,000, supports far less borrowing than its carrying figure suggests. The lender has been quietly running the third column of that table all along. Everything a lender does about security is an answer to that question.

An analyst reads the basis of preparation and the notes first, before the profit line, for the same reason foundations are checked before the paint is admired. Two things get looked for. Whether the accounts say anything about a material uncertainty, and whether the figures that would raise the question are moving in the wrong direction: cash against what falls due, how much of the money owed sits with the largest customer, how old the oldest unpaid bill is. None of that requires new information. Every one of those checks is arithmetic on the sheet itself.

A household meets exactly the same idea without the vocabulary. A household living on one salary is running a concentrated business, and its budget quietly assumes that salary continues. Withdraw the assumption and every number in the budget is measured differently. The fixed deposit that was earmarked for a wedding becomes the money that pays the rent. A street vendor whose stall serves one office block has the same structure as Anjani Stationers. Practitioners rarely ask what a business is worth; they ask which future the figures were measured under, and what happens to those figures if that future stops being true.

Anjani Stationers Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.