The going concern concept is a fundamental principle in accounting that assumes a business will continue to operate for the foreseeable future, without any intention or need to liquidate or significantly reduce its operations. This concept allows accountants to prepare financial statements with the expectation that the entity will remain in business and meet its obligations as they fall due. It directly affects how assets and liabilities are recorded, valued, and disclosed. Understanding this principle is vital for students preparing for ACCA, CMA, or CFA exams, as it underpins various accounting standards and influences decision-making, audit judgments, and financial reporting reliability.
What is the Going Concern Concept?
The going concern concept is one of the accounting principles that presume an entity is to be a going concern, that is, it will operate for a considerable time in the foreseeable future. This assumption holds that the company will not be forced to sell its assets or cease operations because of financial pressures or some other such problem. Instead, it is conjectured that the company will continue to earn income while honoring its obligations in the normal course of business-that is, managing its assets and liabilities.
Going Concern Concept Definition
The assumption underlying the going concern concept is that an entity will continue operations, which must be the foundation on which accountants construct financial statements. In preparing their financial statements, therefore, accountants assume that the assets and liabilities of the entity will continue to be relevant for some separate time. This enables a company to depreciate its assets and amortize its costs, thereby communicating its financial performance that reflects the long-run survival of the entity.
A business that is not deemed a going concern is one that is slowly creeping towards liquidation or closure. In such situations, the assets and liabilities of the business would need to be valued at liquidation values and not at historical costs. This is an important presumption in financial reporting since it enables a more realistic posture of the firm’s financial standing, leaving potential investors, lenders, and other stakeholders with a view of the viability of the company into the future.
Importance of Going Concern Concept
The going concern concept becomes very important because it provides a sound base for preparing financial reports. As it assumes that a business will continue operations, accountants can report the financial health of a company on a long-term basis. This will, on the other hand, help an investor or creditor balance his/her decisions concerning the business with its future prospects.
The Going Concern Concept Influence on Financial Statements
The going concern concept directly affects some of the most relevant parts of financial statements; this is how it affects the balance sheet, profit and loss statement, and cash flow statement.
- Balance Sheets: In a going concern business, assets and liabilities would appear retained at their expected value within the company because the company is still open for business. Therefore, such assets as buildings, machinery, and inventory should be properly valued and relevant for future income.
- Income Statements: Coming into existence will ensure that income and expenses are recognised normally according to business operations, thus reflecting the performance of the company during the time for which it is expected that continued profits will be generated by the operations of a business.
- Cash Flow Statements: The assumption of going concern postulates that a business continues its operating activities in a normal manner. Therefore, it provides a sound basis for cash flow projections. Therefore, it ensures that a company meets its payables, debts, and other operational costs.
Because of the going concern concept, firms can actually give a picture that is more representative of their financial state. This serves particularly well for stakeholders whose interests deal with testing whether the firm is able to earn a profit and continue its operations.
Impact on Investors and Creditors
The going concern concept, to an investor or creditor, is what really matters when analysing the financial statements in order to make decisions. An investor would want to know that the business he is venturing into would still be operational and would provide him a return for his investment. The same goes for a creditor. He would want to be assured before extending any loans that a company would repay him, or his loan would not be a write-off. If the business is not a going concern, it may cause considerable financial uncertainty and, in turn, may complicate attracting an investor or securing loans.
Going Concern Concept Example
Consider a hypothetical example of the going concern concept. A company involved in manufacturing electronic devices is financially sound. The company assumes continuity of operation and displays the same in its financial statements. Equipment is depreciated over the given life, and revenues are recognised on the basis of sales generated from operations. The going concern concept assumes that a company will operate more or less in the normal course for the foreseeable future and will not shut down or liquidate anytime soon.
However, if problems arise, like a dwindling order book or increasing debt, that may question the company’s assumed going concern status. Here, too, there arises a requirement for the company to disclose any uncertainties related to its ability to continue its operation in its financial reports. The company might consider putting all its assets at liquidation value, which may be less than their original cost. This would result in a change in the set of financial statements, thus offering an improved image of the financial condition of the company.
The going concern example portrays how this concept safeguards against the preparation of financial statements on the premise that a business will continue to function.
Advantages of Going Concern Concept
The going-concern concept has serious implications concerning the accuracy, faithfulness, and reliability of financial statements. Such advantages would endow the entity to become rather open with respect to financial information and show the true position of the entity’s finances.
Stability in Financial Reporting
Stability in financial reporting is one of the key benefits of the going concern concept. The reports assume the continuity of the business and therefore reflect the long-term view of the company, making it easier to compare its performance over time. To its stakeholders, this long-term view is important when wanting to determine the company’s growth prospects.
Accurate Valuation of Assets
Going concern ensures that long-term assets are valued appropriately. For example, instead of valuing their asset at current market prices or at liquidation prices, a business can carry such assets to the extent of their expected future benefits. This allows for amortisation or depreciation to be done in a way that reflects the actual benefits received by the business over the life of an asset and thereby presents a more accurate value in the financial statements.
Easier Access to Financing
While being considered a going concern, it becomes easy to get financing. Lenders and investors are more widely attracted to businesses they believe are going to continue and generate returns for those investors. Together, this gives companies higher possibilities in raising capital and expanding their entity. The going concern concept marries confidence for lenders and investors.
Disadvantages of the Going Concern Concept
Despite all its advantages, the going concern concept has its disadvantages as well, some of which can result in misleading financial reporting or assessment of an entity’s financial health.
Misleading Assumptions
One major disadvantage of the going concern concept is that it assumes continuity of existence indefinitely. In circumstances in which a company may be facing financial difficulties but, to the extent possible, continues operations, the financial statements may be construed to be an overly optimistic picture of the financial status of the entity. This can mislead the investors and creditors in their assessments of an entity’s actual financial health.
Difficult to Assess Financial Health
In the same way, the going concern concept may hinder the accurate assessment of real financial health, particularly during times when the company is under serious challenges. If the company is not doing well on a business basis but is able to sustain its operations, its financial statements may portray a sense of balanced stability while it is actually suffering. Such situations may lead to gross miscalculation of the company’s financial position.
Dependence on Management Assumptions
Again, the going concern principle depends a lot on management assumptions regarding the future of the company. In case the management’s judgment is flawed, it may lead to erroneous financial reporting. For instance, if the management takes the view that the company will recover from its financial troubles and it doesn’t, the financial report may not be indicating the real state of affairs regarding the company’s going concern status.
Going Concern Concept FAQs
1. What is an appropriate definition for going concern?
A going concern assumes that the business would continue on for an indefinite period of time unless it is forced to liquidate.
2. What is meant by a going concern convention?
The going concern convention holds that, in the foreseeable future, an entity will continue business operations and not liquidate its assets.
3. What is the 7th accounting concept?
The 7th accounting concept is the consistency concept, which holds that the same accounting principles should be consistently applied from one period to another.
4. What is the concern principle of accounting?
The concern principle in accounting is the going concern principle that assumes a business will continue the operations and not be forced into liquidation.
5. What is the going concern concept?
The going concern concept in accounting assumes that a business will continue its operations for the foreseeable future and will not go for liquidation.
