Every business prepares its financial statements based on certain assumptions, and one of the most important is the going concern basis of accounting. This assumption means that the business is expected to continue its operations for the foreseeable future without any intention or necessity to liquidate or significantly curtail its scale of operations. It plays a foundational role in how financial information is recorded and presented. The going concern concept influences valuations, asset management, and financial planning. Understanding it is critical not only for accountants but also for investors, creditors, and regulators who rely on accurate and consistent reporting.
Definition of Going Concern Basis
The going concern basis of accounting assumes that a company will remain in business long enough to carry out its objectives and commitments. It implies that the organization has neither the intention nor the need to liquidate its assets or cease trading in the near future. This assumption allows accountants to defer the recognition of certain expenses to future periods when the business is still expected to operate and generate income.
Key Characteristics
- Assets are recorded at cost, not liquidation value
- Liabilities are expected to be paid in the normal course of business
- Revenues and expenses are matched over multiple periods
- Amortization and depreciation are applied over useful lives
Importance of the Going Concern Concept
The going concern basis is fundamental to accrual accounting. Without it, businesses would have to apply liquidation accounting, which involves different valuation methods and often results in drastically different financial statements. The assumption ensures the continuity of financial reporting and provides a consistent framework for evaluating performance over time.
It also helps external users such as investors, banks, and tax authorities understand the long-term viability of a business. If the going concern assumption is not valid, users would need to take a more cautious approach in their financial decisions.
Indicators of Going Concern Doubt
While the going concern basis is generally applied, there are situations where this assumption may no longer be valid. A company must regularly evaluate whether any events or conditions cast significant doubt on its ability to continue operating.
Common Indicators Include:
- Recurring operating losses or negative cash flows
- Default on loans or inability to obtain financing
- Significant legal issues or regulatory actions
- Loss of key customers or suppliers
- Overdue liabilities or payroll issues
- Plans to liquidate or cease operations
If such conditions exist, management must assess whether the company has plans in place to mitigate the risks and whether those plans are likely to be effective.
Going Concern and Financial Statements
When preparing financial statements, the going concern basis affects several accounting treatments and disclosures. If a company is no longer considered a going concern, it must switch to a different basis of accounting, and this must be clearly disclosed in the notes to the financial statements.
Impact on Accounting Practices
- Assets may need to be written down to their recoverable amount
- Liabilities may become immediately payable
- Intangible assets and goodwill may be impaired
- Prepaid expenses may not be recoverable
Auditors also have a responsibility to evaluate the going concern assumption. If there is material uncertainty, it must be disclosed, and an appropriate note must be included in the audit report.
Management’s Responsibility
It is the responsibility of the company’s management to assess and confirm whether the going concern assumption is appropriate. This evaluation must consider all available information about the future, typically for a period of at least 12 months from the end of the reporting period.
Steps in the Assessment:
- Review of current financial conditions
- Examination of budgets and forecasts
- Consideration of industry and economic trends
- Identification of risks and contingency plans
If management determines that the company may not be able to continue operating as a going concern, appropriate disclosures must be included in the financial statements to inform users of this uncertainty.
Going Concern vs. Liquidation Basis
If a business is no longer considered a going concern, the liquidation basis of accounting may be used instead. This involves valuing assets based on their estimated net realizable value and recognizing liabilities as immediately due.
Key Differences
- Going Concern: Assets depreciated over useful lives
- Liquidation: Assets valued at sale or scrap value
- Going Concern: Liabilities settled in normal business course
- Liquidation: Liabilities settled immediately, possibly at a discount
This shift in basis can significantly alter the picture painted by a company’s financial statements and must be treated carefully to ensure transparency and accuracy.
Examples of Going Concern in Practice
Let’s consider a small manufacturing company that has been operating for several years. Despite a downturn in the economy, it continues to generate modest profits, pays its bills on time, and has access to credit. The going concern assumption remains valid.
In contrast, another firm in the same industry has reported losses for three consecutive years, defaulted on a bank loan, and lost major clients. Its auditor may raise doubt about its ability to continue, and management may need to prepare financial statements under a different accounting basis.
Disclosure Requirements
Accounting standards such as IFRS and GAAP require full disclosure when there is substantial doubt about a company’s ability to continue as a going concern. These disclosures typically include:
- The nature of the events or conditions creating the doubt
- Management’s plans to address the situation
- The period covered by the assessment
- Any changes to the basis of accounting
Transparency in these disclosures is essential for stakeholders to make informed decisions about the company’s future.
Role of Auditors in Going Concern Evaluation
Auditors play a crucial role in assessing the going concern assumption. They are required to evaluate management’s assessment and determine whether it is reasonable. If there is significant uncertainty, they must include a going concern emphasis of matter in the audit report, or even issue a modified opinion if disclosures are inadequate.
The going concern basis of accounting is a fundamental principle that underpins financial reporting. It allows businesses to record assets and liabilities based on the expectation of continued operation. Proper application of this principle promotes consistency, reliability, and comparability in financial statements. However, when there are doubts about a company’s ability to continue, proper evaluation, disclosure, and possibly a change in accounting basis are essential. Whether you’re a business owner, accountant, or investor, understanding the going concern assumption is key to interpreting the financial future of any organization.