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.
Explained
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 anticipated future and has no intention or need to close materially its operations.
On the other side, if there is any intention or need of the company to close its operation then that the financial statements of the company will be prepared using the 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 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 will survive in the future.
Please note that there are three fundamental accounting assumptions in accounting – going concern, Consistency, and Accrual assumption.
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:
Now if the situation arises where 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 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 in spite of many business failures, the enterprises have a fairly 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 break up basis the assets are reported at the amount which is likely to be realized from the sale of the given asset and liabilities are reported at the amounts at which they are expected to be settled.
We can take the example of a venture which is established for a particular purpose like for setting up a shop temporary for some seasonal work like selling of candles and decorative items at the time of Christmas where the business comes to an end as soon as the purpose is solved i.e. when the Christmas is over. 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.
Advantages
- The sound basis for the measurement of income or the profit is provided by the going concern principle. Due to this, the product that can be used in the business for more than a year or having future economic benefits is recognized as a fixed asset, not as an 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 giving them the assurance that the enterprise will keep working in the manner 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.
Drawbacks
- 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 that arise at the time of liquidation get ignored which results in the non-disclosure of important 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 various laws.
- The increment in short term borrowings or the overdraft limit not resulting in an increase in business.
- Recurring trading losses as profit is the important 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 key role in the long term survival of the business.
- The patent or the key 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.
Conclusion
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 properly addressed.
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