The Going Concern Assumption: A Critical Appraisal

Author(s): James M. Fremgen

Source: The Accounting Review, Vol. 43, No. 4 (Oct., 1968), pp. 649-656
Published by: American Accounting Association
Stable URL: https://www.jstor.org/stable/243624
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 The Going Concern Assumption:
A Critical Appraisal
James M. Fremgen
SCARCELY an introductory account-
ing text fails to advise its neophyte
reader that the accounting entity is
assumed to be a going concern, With this
obviously important (It was in italics,
wasn't it?) bit of information carefully
stored in his mind and/or notebook, the
student proceeds with his study of ac-
counting-quite likely never again to
encounter that obviously important idea,
except, perhaps, on an examination.
Certainly, the going concern or continuity
assumption seems to be one of the most
firmly entrenched and least controversial
of the basic concepts (conventions? postu-
lates?) of accounting. Yet, a survey of the
accounting literature, particularly the "au-
thoritative pronouncements," causes one
to question the importance and possibly
even the validity of the assumption. Such
is the purpose of this paper.
DEFINITION OF A GOING CONCERN
While it has been phrased in various
ways, the most general statement of the
going concern assumption follows a com-
mon pattern. "In the absence of evidence
to the contrary, the entity is viewed as
remaining in operation indefinitely."' This
view of the entity was originally formulated
in contrast to the once common single
venture, a business enterprise designed to
effect a single and usually substantial
transaction (e.g., dispatching a ship or a
649
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caravan to purchase silks and spices in the
Orient and bring them to Europe for sale).
Such an enterprise was not intended to
outlive the completion of the single trans-
action. The going concern, on the other
hand, is designed to effect an indefinite
succession of transactions. It has no pre-
determined limit set upon its life; it may
continue to function as long as it is suc-
cessful. Unquestionably, there is a sig-
nificant difference of intent between the
single venture and the modern business
corporation. However, one might question
whether it follows that this difference of
intent justifies a different assumption about
the life of the enterprise.
Although generally accepted, the con-
tinuity assumption has not gone unchal-
lenged. A memorandum prepared by
Arthur Andersen & Co. completely rejects
the idea. It alleges that the going concern
assumption is unfounded as a general
premise and is not a proper postulate of
accounting. Worse, the memorandum sug-
gests that the continuity assumption has
often been used by accountants to justify
1 Accounting and Reporting Standards for Corporate
Financial Statements and Preceding Statements and Sup-
plements (American Accounting Association, 1957),
p. 2.
James M. Fremgen is Associate Professor
of A ccounting at the Naval Postgraduate
School.
 650 The Accounting Review, October 1968

ignoring the obvious imminence of liquida- port or refute that view, then the assump-
tion.2 Even writers who accept and use the tion of continuity becomes a meaningless
assumption recognize its limitations. Many charade, a nullity. Worse, if proper ac-
conceded that it is not "a scientific fact or counting depends upon whether or not an
even a completely rational assumption."' entity is a going concern, blind acceptance
Paton admitted that the assumption "is of the assumption may result in misleading
incapable of demonstration in the particu- financial statements.
lar case," although he contended that it
"is thoroughly reasonable and needs little Going Where?
qualification "4 While he employed it to Even if there is evidence that an entity
support his argument, Carson observed, will probably continue to operate indefi-
"The going concern assumption is not nitely, what does continuity imply besides
without defects. Statistics on the length of mere existence? Does it, for example,
life of business undertakings do not support imply continuity of ownership? If it does,
it.) 5 then large corporations whose common
stocks are regularly traded are not going
IMPLICATIONS OF CONTINUITY
concerns. Clearly, such an interpretation
Most discussions of the going concern conflicts with the usual notion of contin-
concept simply observe that the entity may uity. Ladd points out the distinction be-
be assumed to continue indefinitely and, tween the liquidation of a business and the
therefore, will not be liquidated in the fore- sale of a business. In the former case, the
seeable future. If this is all the assumption firm ceases to exist. Its employees lose
implies, then it is a sterile postulate at their jobs. Its customers must seek new
best and is invalid with respect to thou- sources of supply. In the latter instance,
sands of new small businesses which are however, the firm continues to exist, even
organized each year and are destined to though it has new owners and may now be
fail within the year. More attention needs regarded organizationally as a division of a
to be given to the bases for the assumption larger corporation rather than as a sep-
in each individual entity. Perhaps the arate company. Its employees retain their
definition cited earlier should be alteredjobs. Its customers continue to be served.6
to read that "the entity is viewed as re- Chambers further refines the notion of
maining in operation indefinitely" in liquidation. He distinguishes between
recognition of evidence to that effect, not liquidation and orderly liquidation.
forced
"in the absence of evidence to the con- In a forced liquidation, the initiative rests
trary." This change in wording suggests with the enterprise's creditors. Assets are
that continuity should be a judgment sold under duress at prices often disadvan-
based on evidence in the case. Thus, if tageous to the seller. In an orderly liquida-
relevant at all, continuity would be a
conclusion, not an assumption. As a matter 2 The Postulate of Accounting: What It Is, How It Is
Determined, How It Should Be Used, (Arthur Andersen
of fact, if the accountant actually sought
& Co., September 1960), pp. 18-20.
to determine whether there was "evidence 3George 0. May, "Postulates of Income Account-
ing," The Journal of Accountancy, (August 1948), p. 108.
to the contrary" and found none, he could
4W. A. Paton, "Assumptions of the Accountant," in
posit continuity as a conclusion rather than Herbert F. Taggart (ed.), Paton on Accounting (The
University of Michigan, 1964), p. 129.
an assumption. On the other hand, if the 6 A. B. Carson, " 'Replacement Cost' Is Compatible
accountant and particularly the auditor With Going Concern Postulate," The Journal of Ac-
countancy, (January 1949), p. 35.
-assumes that a firm is a going concern 6 Dwight R. Ladd, Contemporary Corporate Account-
without even considering evidence to sup- ing and the Public (Richard D. Irwin, Inc., 1963), p. 44.

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 Fremgen: The Going Concern Assumption 651
tion, on the other hand, the initiative
remains with the management of the
enterprise. Assets are sold or consumed in
the ordinary course of business at prices
as favorable to the enterprise as any then
available.7 The reader will recognize that
orderly liquidation is nothing more nor
less than the normal operations of an entity of existing resources, include the assump-
not faced with forced liquidation. So
Chambers regards it. He points out, "Un-
less a firm is in the process of orderly
liquidation, it can scarcely be described as or charitable organization) must earn a
'going.' "8 Substantially the same idea
has been expressed in different words. The
entity is expected to continue to operate
long enough for it to complete its "existing mere continuity. If we deny that hypothe-
plans and programs"9 or "to carry out its
existing commitments."10 Completion of
existing programs and commitments would
include the conversion of productive re-
sources into salable products and the sub-
sequent sale of such products through nor-
mal market channels, and this is the es-
sential meaning of orderly liquidation.
Ladd suggests that the assumption of
continuity (he calls it "permanence") im-
plies that an enterprise will continue to
maintain its competitive capacity.11 This
implication goes even further than that of
orderly liquidation, for it suggests that
the entity will continue beyond completion
of existing programs by formulating new
ones and acquiring the resources necessary
to implement them. Carson"2 and Sprouse"3
share this view that the going concern
assumption implies replacement of exist-
ing assets. As we shall see shortly, these
writers employ their interpretation of
continuity to support particular approaches
to the question of asset valuation. For the
present, it is sufficient to note that this
interpretation goes far beyond the usual
implication that the entity will not be
forced into liquidation in the foreseeable
future. Yet, it is entirely consistent with
the basic definition that a going concern is
expected to remain in operation indefi-
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nitely. Clearly, such a far-reaching inter-
pretation of continuity must be based on
evidence of probable indefinite existence,
not on the mere assumption thereof.
One final point remains to be considered
here. Does the assumption of a going con-
cern, particularly if it implies replacement
tion of continued operation at a profit? If
we accept the hypothesis that a business
enterprise (as opposed to a governmental
profit in the long run in order to remain in
operation, then the going concern assump-
tion would seem to imply profit as well as
sis, then we must recognize that the bulk
of current accounting practice, with its
income orientation, is misdirected.
CONTINUITY AND ACCOUNTING PRINCIPLES
The study of accounting per se has no
reason to posit abstract observations about
the environment. The facts that the earth
is round and that gentlemen prefer blondes,
for example, may be true; but they have
no implication for accounting. Thus, the
fact (if it is such) that an entity has an
indefinite life must have some implications
for accounting. Otherwise, accountants
should cease to concern themselves with it.
It is legitimate to ask whether accounting
principles and procedures are in some way
determined by the assumption of con-
tinuity. If the going concern concept is
relevant to accounting, then accounting
principles should be predicated, at least
partly, upon it. Further, the accounting
7 Raymond J. Chambers, Accounting, Evaluation and
Economic Behavior (Prentice-Hall, Inc., 1966), p. 204.
8 Ibid.
I American Accounting Association, loc. cit.
10 Eldon S. Hendriksen, Accounting Theory (Richard
D. Irwin, Inc., 1965), p. 88.
Ladd, op. cit., pp. 55-6.
Carson, loc. cit.
13 Robert T. Sprouse, "The Measurement of Finan-
cial Position and Income: Purpose and Procedure," in
Robert K. Jaedicke, Yuji Ijiri, and Oswald Nielsen
(eds.), Research in Accounting Measurement (American
Accounting Association, 1966), p. 113.
 652 The Accounting Review, October 1968
principles applicable to a liquidating con-
cern should be different. If these conclu-
sions are not valid, then the significance of
the going concern assumption in account-
ing is unspecified, if not nonexistent.
Postulate and Principles
Clearly, Moonitz believed that contin-
uity is significant in accounting, for he
listed it as one of the basic postulates on
which accounting principles rest."4 So did
Sanders, Hatfield, and Moore"5 and Gil-
man16 before him, although these earlier
writers referred to it as a convention rather
than a postulate. Yet, the ensuing discus-
sions of accounting principles failed to
make clear how the going concern postulate
determines the principles to be applied.
Although Sprouse and Moonitz17 suggested
that their broad accounting principles de-
rive from the postulates set out in the ear-
lier research study, their discussions of
specific principles do not include explana-
tions of how the continuity postulate led to
them. The same is true of Sanders, Hat-
field, and Moore's report. Although they
considered the going concern to be an
important convention, they did not use it
directly to justify specific principles. Per-
haps this lack of direct linkage between the
postulate and principles simply reflects
the fact that the going concern is so funda-
mental an assumption that it needs no
justification in terms of consequent prin-
ciples. Perhaps, too, the postulate is ac-
cepted at the outset because it appears to
be reasonable but is not referred to again
because it is not sufficiently specific to
support any particular principle.
Possibly the strongest single indication
of the usefulness of the going concern
postulate as a basis for accounting prin-
ciples is the fact that different accounting
principles are applied to a liquidating con-
cern. The bases of asset valuation in a
statement of affairs are different (except
in the case of cash) from those in a balance
sheet. Also, the scope of reported liabilities
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in the former statement is more consistent
with legal considerations than with econo-
mic concepts. There does not appear to be
any evidence that the accounting principles
applied to a single venture were greatly
different from those used in a going con-
cern, however. This might be explained by
the fact that a venture was expected to
undergo an orderly rather than a forced
liquidation. But, if this is so, why should
the going concern assumption be necessary
to contrast the modern business enterprise
with its limited-life predecessor?
A ccrual A ccounting
May alleged that all allocations between
past and future depend upon the assump-
tion of continuity of operations." In other
words, the accrual basis of accounting
assumes that the entity is a going concern.
Therefore, depreciation accounting, as an
example, would be based upon the con-
tinuity postulate. Consequently, in an
entity faced with forced liquidation, depre-
ciation accounting would be inapplicable.
Let us examine this implication. Suppose
that a large department store is to be
operated by a receiver for one year in order
to liquidate its inventory at prices rea-
sonable favorable to the creditors. The
receiver has decided that continuation of
the store's delivery service is consistent
with this objective. In order to do this,
however, he must purchase a new delivery
truck with a total useful life of five years.
Clearly, the entity here is not a going con-
cern. How, then, will it account for the
delivery truck? It will record it initially at
14 Maurice Moonitz, The Basic Postulates of Account-
ing: Accounting Research Study No. 1 (American Insti-
tute of CPAs, 1961), pp. 38-41.
15 Thomas Henry Sanders, Henry Rand Hatfield, and
Underhill Moore, A Statement of Accounting Principles
(American Accounting Association, 1959), p. 3.
16 Stephen Gilman, Accounting Concepts of Profit (The
Ronald Press Company, 1939), p. 205.
17 Robert T. Sprouse and Maurice Moonitz, A Tenta-
tive Set of Broad Accounting Principles for Business
Enterprises: Accounting Research Study No. 3 (American
Institute of CPAs, 1962), p. ix.
18 May, loc. cit.
Fremgen: The Going Concern Assumption 653
its actual cost. The difference between
this cost and the estimated resale value
at the end of one year will be charged to
depreciation expense for the year of opera-
tion in receivership. Thus, at the end of
the year, the asset will be reported at its
originally estimated realizable value. How
does this treatment differ from conven-
tional depreciation accounting? Only the
amounts are affected by the prospect of
forced liquidation. The principle is the
same. The useful life and the estimated
salvage value may be different from what
they would be if the store expected to use
the truck for five years. Hence, the amount
of depreciation would likely be different;
but the principle of depreciation account-
ing would be applied in the same way. Had
the store already owned the truck when
the receiver assumed responsibility for
operations, depreciation accounting would
have continued, although the annual ex-
pense might have been adjusted to conform
to a shortened expected useful life and a
revised salvage value. This is no different
from the procedures applied by a going
concern when an asset's useful life is re-
determined.
Accounting for Income Taxes
If allocations between the past and the
future were really predicated upon the
going concern assumption, one might
reasonably expect that this assumption
would be raised in support of the contro-
versial principle of income tax allocation.
Yet, the Committee on Accounting Pro-
cedure recommended the recognition of a
deferred tax liability that is not currently
payable and, indeed, will never be payable
unless there are future profitable opera-
tions, without so much as mention of the
going concern concept. Somewhat incon-
sistently, though conservatively, the Com-
mittee denied the existence of an asset in
connection with an operating loss carry-
forward."9 Clearly, however, all that need
be assumed to justify recognition of such
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an asset are future operations at a profit.
In a similar manner, the Accounting Prin-
ciples Board found itself capable of de-
ciding-twice-how the investment credit
should be reported, without having to
resort to the going concern postulate.20
The purpose of the foregoing paragraph
is not to deny the validity of income tax
allocation or of the accepted method
(whatever it may be) of accounting for the
investment credit. Nor is it to suggest that
these accounting principles violated the
assumption of continuity. It is simply to
point out that accounting principles which
touch directly upon the future operations
of the entity have been formulated without
explicit reference to the going concern
assumption. Perhaps this is as it should be.
Accounting principles should be predicated
upon observations of and/or logical in-
ference of their usefulness to the readers of
financial statements.21 They ought not con-
flict with obvious facts about the environ-
ment within which accounting functions-
that is, with postulates, as Moonitz used
the term. But the statement of a postulate
does not lead directly to a principle. It
merely defines a condition in light of which
a useful and justifiable principle should be
conceived.
ASSET VALUATION
Liquidating Value
Most references to the going concern
assumption occur in discussions of the
proper basis for asset valuation. The most
familiar application of the going concern
19 Accounting Research Bulletin No. 43: Restatement
and Revision of Accounting Research Bulletins (American
Institute of CPAs, 1953), Ch. lOB.
20 APB Opinion No. 2: Accounting for the "Investment
Credit" (American Institute of CPAs, 1962) and APB
Opinion No. 4: Accounting for the "Investment Credit"
(American Institute of CPAs, 1964). At the time of this
writing, the Accounting Principles Board has circulated
an exposure draft of a new opinion on accounting for
both deferred taxes and the investment credit. In this
draft, the going concern concept is specifically stated as
a basic assumption.
21 James M. Fremgen, "Utility and Accounting Prin-
ciples," TEE ACCOUNTING REVIEW, (July 1967), pp.
457-67.
 654 The Accounting
in this context simply justifies ignoring the
forced liquidation value22 or "pouncing
value"23 of the assets. Little attention has
been given to evidence tending to support
or refute the assumption, however, Paton
did caution that, even in an entity pre-
sumed to have an indefinite life, an individ-
ual asset that was obsolete or useless should
be reported at no more than its net salvage
value.24 This caution should be viewed as a
general rule. The fact that an entity does
not appear to be faced with imminent
forced liquidation does not mean that each
of its assets is not. For example, once
Studebaker Corporation discontinued do-
mestic automobile production, its facilities
designed for that purpose exclusively were
properly considered as assets held pending
sale at forced liquidation prices. These
properties were not being offered for sale
as part of a going operation. Moreover, no
buyer appeared with the intention of
manufacturing automobiles in the South
Bend facilities. When an assembly plant is
offered for sale for whatever use a prospec-
tive buyer might have in mind (e.g., as a
warehouse), the initiative regarding price
rests with the buyer. Clearly, this is a
case of forced liquidation. Yet, Stude-
baker, as a total entity, was more likely to
continue indefinitely after shutting down
its automobile production than before.
Even if forced liquidation of specific as-
sets is obviously imminent, the problem of
asset valuation may not be solved. Ex-
plicit denial of continuity does not neces-
sarily lead to a specific monetary value for
the assets awaiting disposition. Perhaps no
objectively determinable liquidation value
can be established until one or more bids
have been received. In such a situation,
the assets held for sale may continue to
appear in the balance sheet at original cost
less accumulated depreciation, with a foot-
note disclosing their status and the likeli-
hood of a loss at the time of ultimate
disposition.25
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Review, October 1968
Historical Cost
Asserting that the going concern assump-
tion justifies ignoring forced liquidation
value in the measurement of assets does not
say what the proper basis of asset valua-
tion should be. Many early writers ap-
parently took the opposite point of view,
however. Rejection of forced liquidation
value was taken as proof that assets should
be valued at historical cost.26 Inasmuch as
historical cost was then widely accepted as
the only alternative, this point of view is
not surprising. Nevertheless, no logical
relationship between the going concern
concept and historical cost was ever demon-
strated. Rather, there were two essentially
separate notions: the entity was a going
concern and assets should be reported at
historical cost. These notions were coinci-
dental; there was no causal relationship
between them.
Current Values
In 1949, Carson argued that replacement
cost is more compatible with the going
concern assumption than is historical cost.
"The assumption of an indefinite life,"
he contended, "provides not so much a
basis for conventional depreciation ac-
counting [based on historical cost], as a
reason for thinking in terms of replace-
ments and replacement costs."27 Edwards
and Bell specifically accept the going con-
cern assumption in choosing to concentrate
on the business profit concept, which en-
22 Paton, op. cit., p. 128.
23 Sanders, Hatfield, and Moore, icc. cit. Creditors, of
course, are here envisioned as pouncing on the fast
dwindling assets of a moribund concern.
24 W. A. Paton, "Aspects of Asset Valuation," THE
ACCOUNTING REVIEW, (June 1934), p. 124.
25 In its 1963 annual report, Studebaker provided for
anticipated losses on disposition of its South Bend facil-
ities by an extraordinary charge to income. Offsetting
credits were made to plant and inventory accounts and
also to both current and long-term liabilities.
26 W. A. Paton and A. C. Littleton, An Introduction to
Corporate Accounting Standards (American Accounting
Association, 1940), pp. 10-11. Gilman, op. cit., p. 81.
May, op. cit., pp. 110-11.
27 Carson, loc. cit.
 Fremgen: The Going Concern Assumption 655
tails the valuation of assets at current
out,
[replacement] cost.28 Similarly, Ladd for example, that a complex mining
recog-
nizes indefinite existence as a basic con-
vention of accounting and regards replace-
ment cost as the most appropriate basis of
asset valuation on both theoretical and
practical grounds.29 Sprouse, too, finds
replacement cost more consistent with
continued operations.30 This conclusion
follows quite naturally from the position
noted earlier, that continuity implies re-
placement of assets, so that the entity will
outlive its shortest-lived assets.3'
Chambers rejects replacement cost as
the preferable basis of asset valuation. He
recommends, instead, use of the current
cash equivalent of the asset, the price at
which it could be realized in the process of
orderly liquidation. This price, he argues,
is wholly consistent with the notion of
continuity of operations.32 Sprouse and
Moonitz advocate net realizable value as
the general basis of inventory valuation,
presumably in accordance with the under-
lying postulates, which include conti-
nuity.33 Net realizable value, it would seem,
is fundamentally the same thing as current
cash equivalent in the case of inventories.34
Going Concern Value
The going concern value of an asset is
the present worth of the future cash flows
that the asset may be expected to generate.
One might be tempted to conclude that,
in theory, this is the basis of asset valua-
tion most consistent with the going con-
cern assumption. It is, of course, subject
to the important practical limitation that
it cannot be measured objectively. Future
cash flows cannot be predicted with
certainty. Further, cash flows attributable
to individual assets employed in harmony
(e.g., plant and machinery) are indetermi-
nate. Thus, where several assets are mu-
tually interdependent in the production
process, the total future cash flows from
production operations could be related to
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any or to all of the assets. Canning pointed
installation might be wholly inoperable for
want of a single boiler tube. Thus, with all
other assets already in place, the anticipa-
tory value of that boiler tube is equal to
the entire stream of expected cash flows
from operation of the mine.35 While this
may be a valid, if extreme, application of
marginal analysis, it is hardly a useful
basis for the valuation of individual assets
in financial reports. Thus, going concern
value is a measure that can be applied
usefully only to the entire entity. Even
then, it cannot be quantified with the de-
gree of objectivity that accountants nor-
mally demand. Yet, in the abstract, it
would seem wholly compatible with the
assumption of indefinite existence.
CONCLUSIONS
A review of the foregoing discussion sug-
gests three general conclusions.
1. Although one of the most hallowed
concepts in the literature of accounting,
the going concern assumption has had no
important influence on the formulation of
accounting principles. Various writers have
found it to be consistent with significantly
different principles of asset valuation.
Official pronouncements on accounting
28 Edgar 0. Edwards and Philip W. Bell, The Theory
and Measurement of Business Income (University of
California Press, 1961), pp. 90-2 and 275.
29 Ladd, op. cit., pp. 43 and 55-6.
30 Sprouse, loc. cit.
31 Of course, as the shortest-lived assets are replaced,
others take their place as the shortest-lived. Hence, the
firm always has short-lived assets which must be re-
placed in order for the full benefit to be obtained from
the longer-lived items. Carson, loc. cit.
32 Chambers, op. cit., pp. 92 and 204.
33 Sprouse and Moonitz, op. cit., pp. 27-8.
34 As a matter of fact, Chambers indicates that the
current cash equivalent of manufactured inventories is
the current replacement cost of the goods and services
sacrificed in production (op. cit., p. 232). This is equiva-
lent, in effect if not in initial premise, to Edwards and
Bell's "current cost." Thus, Sprouse and Moonitz
appear actually to come closer to current cash equiva-
lent in their recommendations regarding inventories
than does Chambers himself.
35 John B. Canning, The Economics of Accountancy
(The Ronald Press Company, 1929), pp. 189-90.
 656 The Accounting Review, October 1968
principles have largely ignored the con-
tinuity assumption in developing argu-
ments to support their conclusions.
2. There is no general agreement as to
the exact implication of the going concern
concept. It has been held to mean simply
the absence of an imminent forced liquida-
tion. It has been said to mean that the
entity will survive long enough to permit
completion of present programs and the
orderly liquidation of assets now held.
It has been extended to imply replacement
of present assets with new ones to be used
in completing present and future programs.
Finally, it can quite logically be construed
to mean continued operation at a profit.
Perhaps this diversity of interpretation
helps to explain why the concept is not
widely used to support proposed account-
ing principles.
3. Continuity is a tenuous assumption at
best. The accountant should not assume
that a firm is a going concern. He should
investigate to ascertain whether such is or
is not the case. If continuity were a valid
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general postulate upon which accounting
principles must rest, then there would be
no principles for the liquidating concern.
Yet, there are far too many liquidating
concerns for accounting to ignore them.
Nor are they ignored. Accounting prin-
ciples for the firm undergoing forced liqui-
dation do exist. They follow from an
inescapable conclusion that the entity is
not a going concern. In the same way,
principles for the continuing firm should be
applied only where there is evidence that
the entity will operate in the future.
In summary, then, the going concern
concept may be a valid description of the
accounting entity, if it is justified by evi-
dence in the particular case but not if it is
offered as an untested general assumption.
Even where it is a valid description of the
entity, however, it does not help to formu-
late meaningful accounting principles. It is,
at best, an innocuous observation about
the environment in which the accountant
does his work. It offers him no real guidance
in the conduct of that work.