Why Going Concern Concept is Important for Companies
The going concern concept assumes that a business entity will continue running its operations successfully during and beyond the next fiscal period. The going concern concept determines a company’s ability to make enough money to avoid bankruptcy and stay afloat.
This blog is a detailed overview of the going concern concept, its importance, evaluation, benefits and limitations. Read on!
What is the Importance of a Going Concern Concept?
The going concern concept is an important aspect of the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
GAAP is a common set of accounting rules, procedures and standards issued by the Financial Accounting Standards Board (FASB) for financial reporting. On the contrary, IFRS is a non-profit and public interest organisation established to develop understandable, high-quality and globally accepted accounting and sustainability disclosure standards.
A business is unable to perform prepaid or accrued expenses without this going concern concept. This concept also allows a business to defer some prepaid expenses to future accounting years rather than considering them all at once.
It also plays a significant role in calculating a company’s assets. The concept also defines a company’s future operations, based on which the depreciation and amortisation of assets work.
What Are the Assumptions of the Going Concern Concept?
The primary assumption is that a business will continue to operate endlessly until it stops due to bankruptcy or liquidation of assets. For making this assumption work, some factors need to be taken care of, which are as follows:
1. Profitability
The aspect of profitability is one of the main assumptions of a going concern business. For instance, if a business is currently making a loss, there is a high chance that it will be profitable in the long term and grow yearly.
2. Acceptability of Product or Service
A business runs on the basis of the going concern concept. For this, the product price of the company has to be reasonable to beat its peers and retain customers.
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.
3. Cyclic Revenue Growth
When the demand for a product is cyclic in nature, there might not be constant top-line and bottom-line growth. This might affect revenue and hinder profitability due to fixed costs.
How to Determine the Going Concern Concept?
The management team can determine whether a company will be able to continue its operations in the future or not. If the firm’s financial condition concludes to either liquidate assets or curtail operations, they need not prepare financial statements on a going concern basis. However, if the firm manages to continue operations, then the financial statements have to be on a going concern basis.
You can follow these steps to determine whether a business is a going concern or not:
Step 1: Use different ratios to check your company’s financial position. You can do this by using current ratio, debt ratio and net income to net sales ratio.
Step 2: Prepare your company’s financial statement and assemble an annual report with the current income, expenses and other listed assets.
Step 3: Finally, monitor the business, and in case you identify any negative trends, start rectifying them.
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What Are the Evaluation Items of Going Concern?
The auditor evaluates the ability of an entity to continue as a going concern for a period of one year from the previous accounting year. The auditor considers the following items to decide whether an entity is a going concern or not:
- Negative trends in operating results, such as losses, obligations and liquidity.
- Loan defaults by the business entity.
- Denial of trade credit to the company by its suppliers.
- Legal proceedings against the company.
- Covenant compliance certificate.
- Uneconomical long-term commitments.
What Are the Advantages of a Going Concern Concept?
The main advantages of a going concern concept are as follows:
- During their formation years, companies undertake the substantial purchase of fixed assets that involves immediate expenditure. The going concern concept helps in recording the value of such assets.
- It acts as a foundation for recording a business’s profits and losses for a particular accounting year.
- It records and bifurcates the assets and liabilities of the company at a cost to ensure security and continuous long-term growth and expansion.
What Are the Disadvantages of a Going Concern Concept?
The limiting disadvantages of a going concern concept are:
- Financial reports are generated at the cost value and not on the basis of the current market value of the company. This means that the evaluation of the company’s assets is based on the market value, and in the event of liquidation, the evaluation value will be different from the cost value.
- In case of a company’s liquidation, the financial statements will be calculated on the basis of the going concern concept, which might deceive the stakeholders.
- Any change in law may affect the going concern concept of the organisation, which will affect the recording of the financial transactions.
Final Word
The primary requirements for a company to sustain and stay profitable for the long term are proper business foresight and operational efficiency. In this regard, the going concern concept has the resources needed to continue operating indefinitely. It also gives a more realistic image of the business for the long term.
FAQs
Ans: As per principles of accounting, a corporation is considered to be a going concern if it has adequate resources to operate indefinitely. The financial statements of such businesses reflect their ability to operate long enough to carry out their current obligations, objectives and commitments.
Ans: Some factors affecting the going concern of a business are:
• Low current ratio: If this ratio is less than one, then the company does not have enough cash and other assets to pay short-term liabilities.
• Unable to get a loan: If a business is incapable of getting a loan, then it means that lenders have low or zero confidence in the firm to pay it back.
• Loss of employees: If the key personnel of a company resigns and cannot be replaced, then it is a big drawback for the company.
Ans: If your business is a going concern, it is considered good for the time being. It simply means that the business is able to make payments and be operational even after facing financial distress.
Ans: Some other accounting concepts besides going concern are entity, accrual, money measurement, periodicity, matching, cost, dual aspect, materiality, etc. The main objective of such accounting concepts is to achieve consistency and uniformity in preparing and maintaining financial statements.
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully. This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.Before you go…
