What is Going Concern Concept?
Accounting concepts have many theory bases, which are the basic ideas that hold foundational accounting concepts. These theory bases are considered for general practices in all accounting activities. These include the business entity concept, accounting period concept, money measurement concept, cost concept, and the going concern concept.
The book of accounts (which holds all financial information of a business entity) is generally prepared by following some accounting assumptions. Going concern concept in accounting is one such assumption where it is assumed that an organization will carry out its operations for the foreseeable future. It implies that there will be no force on the firm to discontinue its operations and liquidate its assets at very low costs.
We will explain going concern concept in this article where you will understand the significance of going concern concept and also get to see some going concern concept examples to clarify this assumption.
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Going Concern Concept in Accounting:
Going concern concept is an assumption that a business entity will not be forced to halt its operations in the near term and will not need to liquidate its assets. The business is expected to operate for the foreseeable future or at least for the next twelve months.
The going concern concept assumes that the organization will be able to generate income and meet its obligations.
The importance of going concern concept is huge in general accounting principles (GAAP) as it is one of the key assumptions of GAAP.
Going concern assumption allows an accountant to defer recognition of specific expenses to a later point in time since the entity will still be in business in the future. This is another major significance of going concern concept which allows assets to be used most effectively.
The term foreseeable future is defined by IAS 1 and Presentation of Financial Statements gives the foreseeable future to be a time span of at least twelve months (which is calculated from the end of the last reporting period).
Determining the Going Concern of a Business:
The leadership team or the business owners determines if the company is able to continue its operations in the future or not. Upon determining the stability of the company, the firm then applies the going concern basis of accounting to prepare its financial statements. If the management of an organization concludes that there is no other way but to either liquidate assets or curtail the scale of its operations, then they need to prepare their financial statements on some other basis (for example break-up basis) but not growing concern basis.
During an economic crisis, the concept of growing concern becomes all the more important and relevant.
It is the management’s duty to estimate if their financial statements can be prepared on a growing concern basis or not.
To determine if the company is able to continue its business for the foreseeable future, the business entity’s management needs to evaluate various uncertain future events, conditions, or outcomes.
As per International Standards on Auditing, ISA 570, there are three factors any management must consider to figure out if they can prepare their financial statements based on the growing concern basis or not:
The further into the future an event or condition occurs, the greater is the degree of uncertainty associated with it. Due to this reason, the financial reporting framework (that requires management assessment explicitly) in general specifies the timeframe for which the firm’s management needs to consider all available information.
The judgment about the outcome of an event depends on the complexity and size of the business entity, the degree to which external factors affect the entity, and the nature and condition of the business.
The judgment about the future is based on all the information available when the judgment is being made. There could be subsequent events that result in outcomes that are not consistent with judgments that were reasonable when they were made.
Going Concern Concept Examples:
Let us see some examples of the going concern concept:
A company ABC Ltd. makes a specialized chemical and sells it in the market. All of a sudden the government of the country where ABC operates puts a ban on the manufacture, import, export, and sale of this specific chemical. If manufacturing this chemical is the only operation of ABC Ltd. then the firm will no longer be a going concern.
A company owned by the state is struggling financially. The government grants a bailout to the company and guarantees all pending payments to the company’s creditors. Despite the poor financial situation, the state-owned company is still a going concern.
Hence, the article has included all the essential information regarding the going concern concept.
FAQs on Going Concern Concept
1. What are some of the advantages of going concern concept?
Going concern has several advantages, some of the main ones are:
In the initial years, companies purchase a substantial amount of fixed assets which is part of the immediate expenditure. But the assets’ benefits are spread throughout its year( which is generally over a year). The going concern recognizes the recording of such expense over the life of the assets.
Going concern concept is the basis of recording income or profits over the years they pertain to.
The concept accommodates the classification of liabilities and assets into short term, long term (more than one year usually), and 12-month periods. It ingrains confidence in a company that it will continue to exist in the future.
2. What are some of the disadvantages of going concern concept?
The going concern concept has a few limitations as listed below:
The preparation of financial reports does not take the current market value but they are prepared at cost. If for some reason the company needed to liquidate its assets, the financial reports are then brought to the current market value. The new values can vary significantly from the earlier ones which were prepared at cost.
If the business is shutting down its operations the financial statements are prepared on a going-concern basis. This might give false information as result and mislead the involved stakeholders.
If there are any changes in the law that affects the business, the idea of going-concern might turn out to be impractical to the business. It would bring about abrupt solutions while recording financial transactions.
3. What are some red flags that can affect going concern for an organization?
There is no single factor that can spell doom for a business, but there are many red flags that could be of concern:
Low current ratio - Current ratio gives the ratio of current assets to current liabilities. If this ratio is less than one then it means the company does not have enough cash and other assets which could be easily converted to cash that can be used to pay short-term liabilities.
Loss of employees - If key personnel of a company depart and are not easily replaceable then it can be a burden for the organization.
Unable to get a loan - If a business is incapable of getting more financing then it can indicate that lenders have a low level of confidence in the firm to pay back its loans.