The going concern principle is a key concept in accounting that helps companies stay afloat.
What are the pros and cons of the going concern principle?
How can you ensure your company remains a "going concern?
Learn more about the going concern principle by reading this blog or watching our expert explanation. Do scroll below.
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 to create financial statements, which provide information about a company's current and long-term financial health. This information can be vital for making informed business decisions.
This assumption allows businesses to continue operating without needing to be liquidated or wound down in the event of financial difficulty.Take me directly to
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
We have published a video which outlines the going concern concept
But if you prefer to read, here are the most important aspects
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.
Going concern concept example
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.
Here are a few examples of situations where the going concern concept may be called into question:
- Financial statements: A company's financial statements include the balance sheet, which shows the company's assets and liabilities. If the company does not have sufficient liquidity to meet its short-term obligations, this could indicate that it may not be able to continue as a going concern.
- Risk assessment: A company may assess its risk of not being able to continue as a going concern by analyzing its financial performance over time.
- Business continuity planning: A company may assess the impact of potential disruptions on its operations by estimating the potential financial impact.
- Debt restructuring: A company may assess its ability to meet its debt obligations by comparing its debt to its financial resources.
Going concern concept example in corporates:
Here are some examples of companies that have faced going concerns issues:
- General Motors: In 2009, General Motors faced significant financial challenges and filed for bankruptcy protection. The company's financial statements included a going concern disclaimer, indicating significant uncertainty about its ability to continue as a going concern. However, the company was able to restructure its operations and emerge from bankruptcy, and it has since returned to profitability.
- Lehman Brothers: In 2008, investment bank Lehman Brothers faced significant financial difficulties and filed for bankruptcy. The company's financial statements included a going concern disclaimer, indicating significant uncertainties about its ability to continue as a going concern. Lehman Brothers could not restructure its operations and ultimately went bankrupt, leading to significant financial instability in the global financial markets.
- Kodak: In 2012, Kodak, a major manufacturer of film and imaging products, faced significant financial challenges and filed for bankruptcy protection. The company's financial statements included a going concern disclaimer, indicating significant uncertainties about its ability to continue as a going concern. Kodak was able to restructure its operations and emerge from bankruptcy, but it has faced ongoing financial challenges.
Disclosure of Going concern in the financial statements
If substantial doubt about the entity's ability to continue as a going concern for a reasonable period is alleviated primarily due to consideration of management's plans, disclose the principal conditions and events that initially led to the belief that substantial doubt existed.
Disclosure should include any mitigating factors, including management's plans, that could affect such conditions and events.
If the auditor’s report is modified because of a going concern issue, the company must disclose in a footnote:
- Conditions and events relevant to the entity raise substantial doubts about its ability to continue as a going concern.
- The possible effects of such conditions and events.
- Any mitigating factors and conditions are evaluated by management.
- Possible discontinuance of operations.
- Management’s plans (including relevant prospective financial information).
- The amount or classification of liabilities or the recoverability of recorded asset amounts..
Example of disclosure in the Director's report
Our business activities, performance, strategy and risks are set out in this report. The financial position of the Group, including cash flows, liquidity position and available committed facilities, are discussed in this section, and further information is provided in notes XX to XX of the financial statements.
After making enquiries, our Directors reasonably expect that our Company and the Group have adequate resources to continue operating for the foreseeable future. For this reason, the going concern basis has been adopted in preparing the accounts.
"As of the date of these financial statements, the company has experienced significant operating losses and has a net deficit. In addition, the company has a high level of debt relative to its assets and income. These factors, along with other uncertainties, raise substantial doubt about the company's ability to continue as a going concern.
Management has taken steps to address these issues and is working to improve the company's financial performance. However, there can be no assurance that these efforts will be successful. If the company is unable to generate sufficient revenue or secure additional financing, it may be unable to meet its obligations and may be forced to cease operations.
These financial statements have been prepared on a going concern basis, which assumes that the company will continue to operate and generate profits in the future. However, the company's ability to continue as a going concern is dependent on its ability to generate sufficient revenue and secure additional financing as needed. The ultimate outcome cannot be determined at this time."
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.
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!