Going concern principle
The going concern principle specifies that in preparing the financial statements it is assumed that the establishment will continue its business for the foreseeable future with neither the intention nor the necessity of liquidation, ceasing trading or seeking protection from creditors according to laws or regulations. Accordingly, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business [1].
This is an essential assumption because much of accrual accounting measurement is based on allocating expenses over different future periods. If the business is unlikely to be there in the future this approach is invalid and prudence would require many commodities to be written off at once as valueless. This is, of course, often a bone of contention with auditors when an establishment whose financial statements they have signed then goes out of business a few months later. People who have relied on financial statements find the figures become meaningless when the establishment is no longer in business. The going concern assumption is used to justify the valuation procedures and is, therefore, a major assumption which should be considered by every person analysing the financial statements[2].
In fact, IAS 1, Presentation of Financial Statements, requires management to make an assessment of the establishment's ability to continue as a going concern when it prepares the financial statements. If management is aware of material uncertainties related to occurrences or conditions that may cast significant doubt upon the establishment's ability to continue as a going concern, those uncertainties have to be disclosed. If one concludes that the going concern basis is no longer appropriate, this would have a major impact on the carrying value of assets and liabilities. These would have to be revised considering the need to liquidate or curtail significantly the scale of the establishment's operations [3].
Implications
It is because of the going concern assumptions that[4]:
- Assets are classified as current assets and fixed assets
- Liabilities are classified as short-term liabilities and long-term liabilities
- Unused resources are presented as unutilised costs as against the break-up values as in case of liquidating enterprise. Accordingly, the earning power and not the break-up value evaluates the continuing enterprise.
Examples of Going concern principle
- Businesses assume that their customers will pay their debts within the agreed upon time period and that their suppliers will provide them with goods and services in a timely manner.
- Companies assume that there will be enough cash flow to pay its bills.
- Companies assume that they will be able to continue to generate revenue to sustain operations.
- Companies assume that they will be able to maintain their competitive edge, access capital and continue to innovate.
- Companies assume that they will be able to adjust their strategies and operations to changes in the marketplace.
- Companies assume that they will be able to continue to attract and retain the necessary employees.
- Companies assume that they will be able to comply with all applicable laws and regulations.
Advantages of Going concern principle
The Going concern principle has a number of advantages, which include:
- It facilitates the preparation of financial statements by eliminating the need to separately disclose and value assets and liabilities that would be realised or settled upon liquidation.
- It allows an entity to defer the recognition of certain expenses, such as depreciation, and to recognize income when earned.
- It enables management to focus on the long-term performance of the entity.
- It encourages creditors and investors to extend financing to the entity, as they are confident that the entity will continue to exist in the future.
- It allows entities to use the accrual basis of accounting, which is considered to be more reliable and useful than the cash basis of accounting.
Limitations of Going concern principle
The Going Concern Principle is important in assessing the financial position of a company, however, there are a few limitations to this principle:
- The Going Concern Principle is based on assumptions, which may not always be accurate to the current reality of a business. As such, it may not always be reliable in accurately depicting a company’s financial situation.
- The Principle does not take into account the presence of external factors such as changes in the economic environment and industry trends that may affect the future operations of the business.
- The Principle does not provide any guidance on the value of assets and liabilities, and does not consider the potential impacts that these may have on a company’s future cash flows.
- The Principle does not take into account the potential effects of inflation, which can significantly impact the value of assets and liabilities.
- The Principle does not provide any insight into the potential risks that a company may face in the future, such as changes in the competitive landscape, technological advancements, and political and regulatory changes.
In conclusion, the Going Concern Principle is a useful tool in assessing the financial position of a company, however, it is important to be aware of its limitations.
The Going Concern Principle is related to a number of other approaches, which can be summarised as follows:
- Accrual Basis of Accounting: This approach is used to record transactions at the time when they occur, not when the cash is received or paid. This method is consistent with the Going Concern Principle that assumes financial statements are prepared for an indefinite period.
- Matching Principle: This principle states that expenses should be matched with the revenues that they help generate. This is done to represent the true performance of the company, since expenses incurred in one accounting period may not result in revenues until a future period.
- Conservatism Principle: This principle states that when there is doubt as to the recognition or measurement of an item, the accountant should take the most conservative approach. This means that the accountant should recognise and measure items in a way that minimises profits and assets and maximises losses and liabilities. This principle is consistent with the Going Concern Principle, as it ensures that financial statements are not overstated.
In conclusion, the Going Concern Principle is related to a number of other approaches, such as the Accrual Basis of Accounting, Matching Principle and Conservatism Principle. These approaches ensure that financial statements are prepared in a way that is consistent with the Going Concern Principle, which assumes that the entity will remain in business for the foreseeable future.
Footnotes
| Going concern principle — recommended articles |
| Cost principle — Total capital — Time period concept — Periodicity concept — Accrual method — Abbreviated accounts — Consistency principle — Matching principle — Accounting concepts |
References
- Agostini M. (2018)., Corporate Financial Distress: Going Concern Evaluation in Both International and U.S. Contexts, Palgrave Macmillan, Venice, Italy
- Dr Kan E. (2013)., Audit and Assurance - Principles and Practices in Singapore, CCH Asia, Singapore
- Puttick G., Van Esch S. (2008)., The Principles and Practice of Auditing, Juta & Co. Limited, Cape Town, South Africa
- Tulsian P. (2007)., Fundamentals of Accounting for CA Common Proficiency Test, Tata McGraw-Hill Publishing Company Limited, New Delhi, India
- Walton P., Aerts W. (2007)., Global Financial Accounting and Reporting: Principles and Analysis, Thomson learning, London, United Kingdom
Author: Jakub Irauth
