Going Concern Concept: Importance and Metrics

Going concern concept is one of the twelve accounting principles that is accepted by GAAS. This principle shows that a business will continue to operate unless evidences are produced.

In this article, we will be discussing the going concern concept to understand the importance and applications of this concept.

Table of Contents

• What is Going Concern concept?
• Importance 
• Metrics That Ensure Continuity in Business Operations
• Red flags 
• Aftermath
• Is Going Concern Good or Bad?

What is Going Concern concept?

Also known as the continuity concept in accounting, concept of going concern is one of the principles of accounting. It states that business entities have the resources to continue business operations for the foreseeable future without getting liquidated or discontinued. 

This indicates that the business has enough resources and capital to operate and generate income. A company is considered to be going concern until the sale of its assets does not disable it from continuing business operations. This principle is not included in GAAP but is included in generally accepted auditing standards (GAAS).

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Metrics That Ensure Continuity in Business Operations

When going concern assumptions are appropriate, assets and liabilities are recorded based on the ability to realize it assets and discharge liabilities. For the factual accuracy of the going concern concept, it is important that the business is able to meet the following metrics:

• Business should be able to generate profit since it will ensure that business continues to operate for the minimum period of one year.
• Consumers must be interested in the products and goods offered by the business. This ensures that the business will continue to offer its services and goods for at least the coming 12 months.
• The legal and statutory guidelines must remain the same so that the business model can continue to operate as it is. 

Importance of Continuity Concept in Accounting

The significance of going concern concept is due to the following reasons:

• Going concern concept in accounting is used for deciding the type of reporting that should appear on financial statements. 
• Whenever a company appears to be going concern, it is expected that the firm is using its assets wisely and need not liquidate anything. 
• Going concern is an important principle to determine how a company should reduce its expenses or sell its assets. 
• It helps the company to defer some of the prepaid expenses until the future accounting periods. This will allow the company to efficiently utilize its assets.
• When a business is not going concern, it indicates that the business is not doing well, has gone bankrupt, and its assets have been liquidated. 
• It is also the basis on which profits and losses are recorded for that year to which it belongs. 
• The value of any entity is higher than its breakup value is assumed to be a going concern. This is because, potentially, that entity can continue to earn more profits.

Disadvantages of Going Concern Concept

Financial statements are not based the current market value. However, in the event of liquidation, company will value its assets at market value which will have value determined at cost. Since financial statements are calculated based on the going concern bases, it can be misleading for stakeholders.

• Changes in Law: Any change in law may impact the business and in such a case, the going concern concept may not be viable for the company. This results in immediate corrections in recording financial transactions.
• Mark-to-Market vs Cost Basis: The financial statements are prepared on cost basis instead of Mark-to-Market basis. In the event of liquidation of company, the numbers differ drastically from the one prepared under cost basis when financial statements are drawn on Mark-to-Market basis.
• Potential Misleading Information: If the business is being shut down and financial statements are drawn on going concern basis, the information might not be correct and may mislead the stakeholders.

Red Flag: When is a company not going concern?

The following reasons may indicate that the business is not a going concern. 

1. Usually, companies do not list long-term assets in their quarterly statements or as a line item on the balance sheet. When values of long-term assets are listed, it may indicate financial issues since the company might be planning to sell these assets.
2. If the current ratio (current assets to current liabilities) is less than 1, it might indicate that the business is short of funds and liquid assets to repay short-term liabilities. 
3. Any that faces issues getting credit from lenders might have an unhealthy credit history. This indicates lenders’ lack of faith in the repayment capability of the business. 
4. Continuous losses from one accounting period to next, lawsuits, denial of credit, negative trends in operating results impact company’s ability to continue as a going concern.

When a company is in an uncertain condition of whether it can continue as a going concern, it can do the following as per the accounting standards:

• Financial statements should highlight the details that are causing doubts about the company’s state to change from a going concern to a not going concern. 
• It should also reflect the management’s future plans and interpretation of conditions.
• The company should conduct an audit so as to get an unbiased opinion on whether the company can continue as a going concern for an accounting period of one year.

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Aftermath

Once the business stops being a going concern, the following situations occur:

• Extensive financial reporting will take place since it will be the last accounting period.
• The company will stop operating, liquidate all assets and settle all liabilities.
• Assess whether the net realizable value of assets would be enough to settle outstanding liabilities. 
• Assets and liabilities will be classified as current. The company will convert its fixed assets into current assets.
• Performance measurement will no longer be important, due to which there will be no need for amortization, depreciation, or discounting.

Is Going Concern Good or Bad?

The good aspects of going concern include the following:

• It indicates that a business is stable is not undergoing liquidation or bankruptcy.
• When a business is going concern, it increases the confidence of the investors as well as creditors.
• It implies that the business will continue to remain in operations.

Negative aspects of a business going concern include the following:

• The business is not financially stable and will potentially fail in the long run.
• This will negatively impact the stock prices as well as cripple the interest of investors.
• It may cause difficulties for the company to secure loans.

Conclusion

After the audit, it is important that auditor should highlight any uncertainties detected in the inability of the organization to continue as a going concern. In case, the assumptions about going concern seems to be false, then the auditor should also issue honest feedback on financial statements.