What is Going concern concept? Importance and disadvantages

by Eduyush Team

What is going concern concept?

The "going concern" principle is a fundamental concept in accounting that assumes that a business will continue to operate for the foreseeable future. This means that companies should not only be able to cover their current operating costs but also have enough resources and earn profits to meet their long-term liabilities. 

Accountants use the going concern principle when creating financial statements, which provide information about a company's financial health. 

For example, suppose a company has difficulty paying its debts or significant outstanding liabilities. In that case, this may cast substantial doubt on the entity's ability to continue operating and would be reflected in the financial statements. 

This assumption allows businesses to continue operating without needing to be liquidated or wound down in the event of financial difficulty.

Definition of going concern:

In the absence of evidence to the contrary, an entity is viewed in operation indefinitely.

A going concern is designed to effect an indefinite succession of transactions. It has no pre-determined life limit; it may continue to be operational as long as it's successful. 

There are several factors that contribute to the going concern principle, including.

  • life of the entity
  • the legal and social settings surrounding the entity
  • Its productive and distributive capability
  • financial plans of the entity
  • management of the entity and
  • the proprietor's expectations

Why is the Going concern principle important?

This principle is important because 

  • It provides stability and predictability in financial reporting, which helps investors and creditors make informed decisions about whether to provide funding to a business.
  • It helps ensure that balance sheets provide a true and accurate representation of a company's financial position.
  • Suppose for any reason, it becomes apparent that a company is no longer a going concern. In that case, the accountants must take appropriate steps to reflect this in the financial statements. This may include recording impairment losses or writing off fixed assets.
  •  It allows businesses to continue to operate as usual, even if they are experiencing financial difficulties. This is necessary to enable businesses the chance to recover and return to profitability.

Without the going concern principle, businesses would be forced to wind down operations and liquidate their assets immediately upon experiencing financial problems. This would likely lead to widespread unemployment and economic instability. 

Disadvantages of going concern

There are a few potential disadvantages of relying on the going concern concept when accounting for a business.  

  • If a company is in financial distress, the going concern assumption may no longer be valid. In this case, the company may be forced to file for bankruptcy or liquidate its assets. 
  • It can lead to companies feeling like they must keep going, even when it might be better for them to shut down. The thought is that if a company stops being a going concern, then its creditors will come after it and try to get their money back. This can lead to companies continuing to operate even when they're not making any money, which can obviously cause problems.
  • Reliance on the going concern concept can give managers incentives to continue operating even when it may be more advantageous to shutter the business. This can lead to additional financial losses and increase the chances of defaulting on creditors. 
  • Taxpayers may be footing the bill for companies that eventually go bankrupt despite using Congress-backed accounting methods. Critics argue that it provides an unfair advantage to businesses and creates a moral hazard.

Can you give simple examples of a going concern principle?

A straightforward example of the going concern principle in action is when a company preparing its financial statements includes a footnote disclosing any material uncertainties that could impact its ability to continue operating as a going concern. Disclosing these risks helps investors and other users of the financial statements assess the company's long-term viability. 

Summary

So what is going concern and why should you care? Going concern is a crucial principle of accounting that states that a business will continue to operate into the foreseeable future.

It's one of the areas auditors assess in their audit report about a company's financial stability. The benefits of going concern are pretty straightforward – it gives businesses peace of mind and investors confidence.

But there are also some disadvantages, such as the potential for management fraud if shareholders believe a company is no longer viable. Ultimately, whether or not going concern matters to you depends on your role about the company.

Now that you have understood this concept, try this with one of the past papers on IFRS 9 tested in Jun 2017 in the ACCA Diploma in IFR exams.

If you're interested in learning more about other accounting concepts, we have a wealth of resources on our website. Be sure to check them out!