Going Concern Definition, Principle and Red Flags

By default, it is assumed that the business will indefinitely operate on a Going Concern basis unless there is a strong possibility of closing the operations in the near future. This helps in proper Capital Structure planning and making investments over a long-term horizon. The growth and predictability of the financials will also be smoother across the time periods. Going concern concept is a simple but very important financial accounting principle which stipulates the basis on which financial statements are prepared depending on the likelihood of the company continuing its normal course of business. The concept of depreciation and amortization are based on the assumption that a business will continue to perform its operations in the near future (this period is the next 12 months after an accounting period). Going concern concept is one of the accounting principles that states that a business entity will continue running its operations in the foreseeable future and will not be liquidated or forced to discontinue operations for any reason.

However, when a company’s ability to continue is in doubt, disclosures and alternative financial treatments must be applied. Understanding this concept helps stakeholders, including investors, creditors, and regulators, make informed decisions about the company’s future. The going concern concept is a fundamental principle that shapes the way financial statements are prepared and interpreted. It allows for a more realistic assessment of a company’s financial health and future prospects. Recognizing the factors that can cast doubt on the going concern concept empowers investors and creditors to make informed decisions. While the concept underpins financial reporting, it’s crucial to remain vigilant and analyze potential risks that could threaten a company’s ability to continue as a going concern.

The auditor is required by the Securities and Exchange Commission to disclose in the financial statements of a publicly traded company whether going concern status is in doubt. This can protect investors from continuing to risk their money on a business that may not be viable for much longer. An entity is assumed to be a going concern in the absence of significant information to the contrary. An example of such contrary information is an entity’s inability to meet its obligations as they come due without substantial asset sales or debt restructurings. If such were not the case, an entity would essentially be acquiring assets with the intention of closing its operations and reselling the assets to another party.

Implications of a Negative Report

The going concern concept accounting reveals the true financial integrity of an organization. It is an action an organization conducts to ensure a clearer picture of their financial and growth related concerns. If a company is not a going concern, its management is required to disclose this fact and must provide the reasons for the negative conclusion. Certain accounting measures must be taken to write down the value of the company on the business’s financial reports.

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If the business is expected to continue operations for a long duration, then the cost can be charged over an extended duration. But it is not practical to report the financials at the end when the asset has completed its useful life after many years. Without this concept, there would be uncertainty and doubt surrounding the entity’s ability to continue operating, leading to unreliable financial information. If there’s significant evidence that a privately held business might not be viable under the going concern assumption, the auditor must disclose it in the audit report. Even if the business’s financials aren’t audited, an accountant who has concerns about the business’s viability should disclose those concerns to the business owner.

Thus, the value of an entity that is assumed to be a going concern is higher than its breakup value, since a going concern can potentially continue to earn profits. Factors affecting the going concern concept include financial performance, cash flow, market conditions, regulatory changes, and management’s ability to address future uncertainties. An example of the going concern concept is a company receiving a government bailout during financial difficulties, ensuring its ability to continue operations despite temporary challenges. Another instance where there might not be constant top-line and bottom-line growth, and 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 revenue, hindering profitability due to fixed cost.

This will cause the reported financials and profits to swing rapidly over the different quarters. And this negatively impacts the stability of the accounting process because the Fair Value Measurement (FVM) will generate different values. Without the assumption that the business will operate for a long duration, a company would need to create an expense of INR 1.3 crore (INR 60 lakh + 70 lakh) in this Financial Year. Going concern concept is closely linked with business entity concept, materiality concept and historical cost concept. The auditors of the company are required to analyze the going concern status of a business.

This is because the assets are expected to be utilized for their entire life and they would not be liquidated in the near future. The concept of Going Concern refers to the continuity assumption that is made when building the accounting statements. It is expected that the company will carry on the operations and the business will not shut down in the near future.

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Going concern is a commonly used term for a healthy business but it also is a core accounting principle. This determination, based on a study of the company’s financials, is generally understood to be good for at least 12 months. As explained in the above example, the method of charging the expenses and the revenue will also change. The accounting statements will have to be prepared and reported differently, and the company might face issues when raising capital/investment.

Before an auditor issues a going concern qualification, company leadership will be given an opportunity to create a plan to take corrective actions that can improve the outlook for the business. If the auditor determines the plan can be executed and mitigates concerns about the business, then a qualified opinion will not be issued. On the other hand, if a company intends to close operations, financial statements will reflect such an intent—the company must disclose it. Unless disclosed, it is assumed by default that the company will realize its assets and settle its liabilities. A going concern concept diagram visually represents how the assumption of continuity impacts financial reporting, including the treatment of assets, liabilities, and deferred expenses.

• This can also help in easy measurement and comparison of the financials on a Year-on-Year basis.
• By assuming that the entity will continue as a going concern, financial statements can more accurately reflect the true financial position and performance of the business.
• Unless the company discloses, it is assumed that it possesses adequate assets for fulfilling long-term liabilities.
• A company’s financial health, operational stability, external environment, and legal position are analyzed to assess whether it can continue as a going concern.
• The Financial Accounting Standards Board requires that financial statements reveal the conditions that support an entity’s substantial doubt that it can continue as a going concern.

How to Determine the Going Concern Concept?

In the event of business being liquidated, the financial statements will be calculated on the on going concern basis, which can be misleading for the stakeholders. 1.Companies during the formation years will be purchasing fixed assets that will be requiring expenditure upfront, but such assets will be providing the benefits spread over a long term, that is well beyond one accounting period. Therefore, the going concern concept provides a way to record the value of such assets. A company’s financial health, operational stability, external environment, and legal position are analyzed to assess whether it can continue as a going concern. However, when we consider the concept of going concern, such a change in asset value will be ignored in the short run. The principle highlights the assumption that companies intend to keep assets and generate profits in the future—assets won’t be sold in between.

Financial statements are prepared at cost and not on the basis of current market value. In such a case, if the company in an event of liquidation, will have assets valued at the market value, and as such these values will be different from the value determined at cost. Unless the company going concern concept meaning discloses, it is assumed that it possesses adequate assets for fulfilling long-term liabilities. So, when managements consider such an assumption inappropriate, they prepare financial statements using the breakup basis. The breakup basis reports assets based on the amount that is likely to be realized from the sale and liabilities—the net realizable value. For example, seasonal businesses like firecracker companies opt for the breakup basis.

Going concern concept is one of the basic principles of accounting that states that the accounting statements are formulated so that the company will not be bankrupt or liquidated for the foreseeable future, which generally is for 12 months. It is an important function for a business as it makes it very clear how the business should manage its expenses or commitments to ensure its resources are efficiently managed. The Financial Accounting Standards Board requires that financial statements reveal the conditions that support an entity’s substantial doubt that it can continue as a going concern.

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If Douglas decides to sell the manufacturing plant and equipment, he might get more or less than $402,000, which will change his financial position. At the very least, a company that is deemed a going concern is likely to survive for the next 12 months. The credit crunch can trickle down to suppliers who may be unwilling to sell raw materials or inventory goods on credit. For a company to be a going concern, it usually needs to be capable of surviving a significant debt restructuring or massive financing overhaul if necessary. Companies can go bankrupt without ever having been identified as a going concern issue.

• Another example of this concept is the prepayment and accrual of various business expenses.
• Companies can prepay and accrue expenses only when they and their trade partners believe that they will not shut down operations in the foreseeable future.
• Companies can go bankrupt without ever having been identified as a going concern issue.
• This revaluation may be used to price the company for acquisition or to seek out a private investor.

When an auditor issues a going concern qualification, the way their opinion is disclosed depends on the structure of the business. It is assumed that there will be interest in the goods or services offered by the company. Thus, this concept assumes that the company will continue to sell its product and build a consumer base.

So, if a business is a Going Concern, then it is expected to continue operations for a long time. Depreciation allows the company to split the cost and charge a portion of it in different accounting periods. So, if a machine is acquired for INR 5 lakh (INR 5,00,000), then an annual charge of INR 50,000 (10 % of INR 5 lakh) will be created for 10 years in the statements. So, this forms the basis for the business to accumulate value from the resources that are utilized continuously. And all unused or partially used assets can be reported at their cost of acquisition and not their current value. When the Going Concern assumption is considered, less importance will be given to the current Market Value or Liquidation Value of an asset.