Going Concern Concept in Accounting
Going Concern concept is one of the basic principles of accounting that states that the accounting statements are formulated in such a way that the company will not be bankrupt or liquidated for the foreseeable future, which, generally is for a period of 12 months.
Going concern concept means the ability of a Business to ‘run profitable’ for an indefinite period of time until the concern is stopped due to bankruptcy and its assets were gone for liquidation. When a business stops trading and deviates from its principal business, then there is a high possibility that the concern would likely stop delivering profits in the near-term future. Thus, a Business cannot bear losses for a longer time and erode shareholders’ wealth. A healthy business shows Revenue growth, Profitability growth with margins improvement, and growth in product sales.
Going Concern Concept Assumptions
The primary assumption is that the business will run forever until the business stops due to bankruptcy and assets liquidated. For this, the business needs to have the following –
#1 – Acceptability of the core product
A Business runs on the Going Concern Basis of the products/services they offer to the consumers. The pulse of a business starting from a fruit-seller to a Multi-national company selling IT services would be the same. The owner or the top-management has found new customers and maintain its existing customer’s so as to maintain the Organic and inorganic growth of the company. Retention of old customers and expansion through new customer acquisitionAcquisitionAn acquisition is defined as the act of taking over or gaining control of all or most of another entity's stocks by purchasing at least fifty percent of the target company's stock and other corporate assets. would help to make the business profitable and aids toward the volume growth of the product. The product should be reasonably priced and innovative in nature so that it can beat its peers and retains value for the customers.
#2 – Margin, Growth, and Volumes
The Financials of the Business should speak about the sustainability of the business through Top-line and Bottom-line growth along with higher Operating and Net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses.. An ideal growing concern should have a higher number of product sales compared to last year.
#3 – Cyclical Revenue Growth and Profitability
Another instance where there might not be constant top-line and Bottom-line growth along with increased margin is when the demand for the product is ‘Cyclical’ in nature. For example, the rise and fall of volume in steel products may affect the Revenue, and due to fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity., the profitability may get hinder. But the interesting part of the Business is that it is still following the basic fundamentals, and due to the nature of the business, it is getting a hit.
Examples of Going Concern Concept in Accounting
Example #1 – Page Industries (Jockey India)
Here is a snapshot of a company that has a robust margin and growth.
From the above financials, we can derive that the Revenue growth and the Net profit growth has been consistent for the Page Industry (manufactures Apparels for Jokey brand) during FY14 to FY17. Revenue has increased from INR 1194.17 Cr. in FY14 to INR 2152.88 Cr. in FY17. The Net profit grew from INR 153.78 Cr to INR 266.28 Cr. during this period. The Gross profit marginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold. has been around (50-60) %, followed by a healthy EBIT margin (more than 20%) and a robust Net profit margin (12-13) %. This shows business sustainability due to higher product acceptability (vivid from the Revenue growth) and Operational efficiency (visible from sustainable EBIT margin).
Example #2 – Tata Steel
Below is the snapshot of another example wherein the revenues are cyclical in nature.
Due to the Cyclicality demand of steel across the Globe, the Revenue has gone down from INR 149130.36 Cr in FY14 to INR 112826.89 Cr in FY17, and so is the profitability (from INR 3663.97 Cr in FY14 to a Net loss of INR -4176.22 Cr). However, the margin has been remained robust, but due to higher Finance costsFinance CostsFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains. (INR 4336.83 Cr in FY14 to INR 5072.2 Cr.) and certain Exceptional loss, the Bottom-line got slashed.
When this Concept Turn Out to be Dead?
- As per the Going Concern Concept in Accounting standard, financial statements reveal the ‘true and fair’ value of the business, again when the sale of assets does not questions the capability of the business. Shut down of unprofitable branches, units, etc. does not imply that the concern has stopped performing well until and unless there has been the net lossNet LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet. and reduction in Shareholders fund. Thus the Red-flags can be summed up as follows:
- The inability of a business concern to pay its obligations in spite of sufficient restructuring. In spite of several steps taken by the management, if the business fails to drive profits, and there has been the exclusion of top-level management, then Shareholders might think of an exit.
- Audited reportsAudited ReportsAn audit report is a document prepared by an external auditor at the end of the auditing process that consolidates all of his findings and observations about a company's financial statements. with full Financial Statements are published yearly, whereas only Income statement data are published quarterly. When Accountants and AuditorsAuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. questions about the operational efficiency of its Long-term assets, while to meet its dues, the Assets are being sold.
- Unable to report financials within a stipulated time-frame is a matter of question on the Management. There must be some instances where the management has not given the ‘true and fair value’ of the business to the Auditors. The Auditors generally examines the profitability, loan paying ability, operating and non-operating profits and losses of the company. Continuous losses (where other firms are generating profits in the same segment), loan defaults, lawsuits against the company raises questions regarding the performance of the company.
The prime aspect for a Business remains the capability and integrity of the Management. Proper Business foresight and Operational efficiency are required for a business to sustain and remain profitable for a longer-term. Economic recessions RecessionsEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit. are crucial, which determines the ability of Management when major firms fail to generate profits.
Going Concern Concept Video
This article has been a guide to Going Concern Concept. Here we discuss the top 3 examples of the going concern concept in accounting along with situations where it might not work at all. You may look at the following articles to learn more about Corporate Finance –