Meaning of Going Concern
Any analyst analyzing a company will be left to a basic assumption that the company does not go bankrupt, or file a chapter 11 bankruptcy and this basic assumption that allows the analyst to think that there is no immediate danger to the company and the company can operate till infinity is called as the principle of going concern.
The going concern is one the accounting assumptions wherein the financial statements of the companies are prepared on the basis that the company will continue its working in an anticipated future and has no intention or need to close materially its operations.
On the other side, if there is any intention of the company to close its operation, then that the financial statements of the company will be prepared on a different basis, which the company has to disclose. Otherwise, it is always assumed that the realization of the assets and the settlement of the liabilities are done in the ordinary course of business. It is because of the going concern assumption that an enterprise prepays their expenses before they accrue as they were intent that the company would survive in the future.
Going Concern Assumption Example
Suppose Mr. A purchased a Plant & Equipment in his business paying $400,000 out of $500,000 invested by him. He also paid installation expenses amounting to $2,000. If he is still willing to continue his business, his financial position will be as follows:
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Now, if Mr. A decides to sell plant and equipment, then he might get more than $402,000 or less, so it will change his financial position. However, if the concept of going concern is considered, then such a change in asset value will be ignored in the short run. So this indicates that the intention of keeping assets is to generate benefits/ profits in the future and not for selling it in between. The change in value, which is prevailing at the time off is not realizable, so the same should not be considered by the company.
As per the analysis of the different companies, it is seen that despite many business failures, the enterprises have a relatively high rate of continuance, and there exist entities that have the existence of more than a century even though there is a change of the ownership. Therefore in the majority of the cases, business entities are going concern in accounting, which has proved that it is useful to adopt the assumption of continuity for accounting purposes.
The management of the company decides whether they are satisfied by following the going concern assumption or not. If the management thinks that for their business, this assumption is not appropriate, then the management can prepare the financial statements using the breakup basis. In a breakup basis, the assets are reported at likely to be realized amount, from the sale and liabilities at the amount on which they expect to settle.
We can take the example of a venture established for a particular purpose, like for setting up a shop temporarily for some seasonal work. E.g., selling candles and decorative items around Christmas, where the business comes to an end as soon as the purpose solves. Here, in this case, this assumption cannot be followed as the owner already knows that the duration of business is only a month or two.
- The going concern principle provides the sound basis for the measurement of income or profit. Thus the product that can be used in the business for more than a year or have future economic benefits is recognized as a fixed asset and not expense.
- It is because of this assumption that we classify the assets and the liabilities as long term or short term.
- It directs us to report the assets and the liabilities in the financial statements at the cost not at the market price because the intention of the entity is not to sell the asset but to use it in the furtherance of the business.
- This assumption of going concern accounting principle help the investors by assuring them that the enterprise will keep working like it is expected to perform its business operations, keeping in mind its pre-determined goals.
- In the ordinary course of business, enterprise values its entire current asset at the cost or the net realizable value, whichever is lower;
- If the financial statements of the enterprise, which are likely to get shut down in the future, are prepared based on the going concern assumption, then the truth and fairness of the financial accounts are hampered. It misleads the investors as the firm may get closed after the preparation and publications of financial statements.
- The liabilities arising at the time of liquidation get ignored, which results in the non-disclosure of relevant information to the unsecured creditors.
Possible Indications of Going Concern Problems
- The negative trends in the business include the decrease in sales, an increase in cost, unfavorable financial ratios, recurring losses, etc.
- Loss of the key managerial personnel or the skilled staff, labor hardships of various types such as strikes, etc.;
- The declining liquidity position of the company and not having sufficient financing arrangements;
- Various legal charges against the company including penalties related to different laws;
- The increment in short term borrowings or the overdraft limit not increasing business.
- Recurring trading losses as profit is the vital factor of the growth and survival of the business.
- The bankruptcy of the debtors of the business;
- The inefficiency of the business brings a new range of products as innovation plays a crucial role in the long term survival of the business.
- The patent or the critical license is expired or has been lost.
- The loss of a major customer which is unable to get replaced;
- The default in the repayment of loan installments and failing to get a new source of finance.
Professionals agree that evaluation and disclosure of going concern in accounting provide a critical improvement in the financial statements of the company. It provides for the accurate and complete picture of the financial health of the company to the users of the financial statement. If there is proper disclosure, then the financial statement of the company will be more comparable, which will provide more confidence to the investors that risk in the company is adequately addressed.
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