Going concern assumption is used by businesses to prepare the financial statement. This assumption impacts the accounting treatment, valuation, and presentation of various account balances/transactions/disclosures in the financial statement.
Going concern principle is of the view that the business is expected to continue operations for the foreseeable future. In other words, the business neither needs to curtail its operations materially nor has the intention to do so.
Auditing standard does not define the term foreseeable future. However, the foreseeable period is the next twelve months as per accounting standards.
Further, it’s important to note that if the going concern assumption is not reasonable, the business needs to prepare a financial statement on a break-up basis.
Also read, audit procedures.
Going concern concept/assumption example
Aqua plc extracts water from river hub, filters with the modern pumping system, packs in the bottle and sells in the consumer market.
However, the country’s government has imposed a ban on water extractions for commercial purposes. Since the water bottle is the only product of Aqua plc. And, the business cannot earn revenue after the implementation of the ban. So, Aqua plc may not continue their operations in the future.
Hence, under such circumstances, the financial statement of Aqua plc cannot be prepared using going concern basis. Instead, a break-up basis should be used.
Indicators of going concern problems
Indicators for the going concern problem can be different in different situations. In fact, these problems vary from business to business and time to time. So, there are no definite conditions where we can conclude business is not going concern. Instead, auditors need to use their business understanding, market dynamics, and professional judgment to conclude the business’s going concern assumption.
However, the following are some general indications of the going concern problems.
- There is massive decline in demand for the products/services of the business.
- The business is suffering extensive market competition and declining market share.
- The business is placing higher reliance on short-term financing and overdrafts.
- The business has severe under-utilization of production capacity.
- The business is facing increasing litigations from suppliers and other stakeholders.
- The business cannot ensure timely payment for the suppliers and other business partners.
- Cash flow forecasting reflects that the cash flow position is not expected to improve next coming year.
- The business is not able to retain key employees in for the business.
- The business is not able to invest in the product development phase.
- The business is facing significant losses consistently.
- The business is not able to meet dividend payments to the shareholders.
- The cash flow position is worsening with time.
- Operating cash flow is negative. In other words, the business is not able to generate cash from business operations.
- The business has been unable to meet loan installments, and major business assets have been given as collateral.
Importance of going concern concept/going concern value
Going concern concept is effective as follows.
- Financial stability– The understanding of going concern status helps stakeholders assess the business’s financial status/performance. It helps them in placing reliance on financing structure and other business aspects.
- Operational confidence– Application of going concern assumption depicts that company operations are stable. Further, the business is expected to continue operations in the foreseeable time.
- Helps investors – Investors get a better idea if they would be on the safe side by investing in the business.
- Transparent accounting – Accounting treatment in terms of valuation and presentation differs if the business is going concerned or not.
- A logical approach – The conclusion for going concern status is dependent on logical approach.
- Encourage investment market – Going concerned assessment by auditor leads to higher reliance on the financial statement. It reflects that professional accountants have assessed business ability to continue as a going concerned.