Going Concern Concept Definition, Explanation Examples and Importance

November 30, 2021BookkeepingAdmin Manish

Lenders assess a business’s ability to operate as a going concern before approving loans, ensuring the business can repay its obligations over time. The concept presumes that a business will continue to operate indefinitely unless there is clear evidence to suggest otherwise. A business runs on the going concern basis of the products/services offered to the consumers. The pulse of an industry from a fruit seller to a multi-national company selling IT services will be the same. The owner or the top management has found new customers and maintained its existing ones to keep the company’s organic and inorganic growth.

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This can protect investors from continuing to risk their money on a business that may not be viable for much longer.
For instance, inventory is valued at cost or net realizable value, whichever is lower, assuming it will be sold in the normal course of business.
In accounting, going concerned is the concept that the entity’s Financial Statements are prepared based on the assumption that the entity operation is still operating normally in the next foreseeable period.
A paragraph explaining the basis for the qualified or adverse opinion will be included after the opinion paragraph.

Accounting

If we disregard the going concern and assume the business could be closed within the next year, a liquidation approach to valuing assets would be more appropriate.
It functions without the threat of liquidation for the foreseeable future, which is usually regarded as at least the next 12 months or the specified accounting period (the longer of the two).
By contrast, the going concern assumption is the opposite of assuming liquidation, which is defined as the process when a company’s operations are forced to a halt and its assets are sold to willing buyers for cash.
The assumption is that a company, or other entity, will be able to continue operating for a period of time that is sufficient to carry out its commitments, obligations, objectives, and so on.
However, generally accepted auditing standards (GAAS) do instruct an auditor regarding the consideration of an entity’s ability to continue as a going concern.

The going concern assumption is based on the idea that a company’s financial statements are prepared with the assumption that it will continue to operate and generate income in the future. The purpose of the going concern concept is to provide a stable framework for financial reporting. It ensures that financial statements reflect the long-term perspective of the business, rather than a short-term or winding-up scenario, offering stakeholders reliable information for decision-making. An example of the application of going concern concept in business is the computation of depreciation on the basis of the expected economic life of fixed assets rather than their current market value. Companies assume that their business will continue for an indefinite period of time and that the assets will be used in business until they are fully depreciated.

However, financial figures are the results of how the company is affected by non-financial figures, especially the environment. Assessing the going concern problems in the company is the main Role and Responsibility of the management of the company. The following are the key procedures that management should do to assess the going concern problems. Then we should consider whether auditors put all possible procedures that should be performed or not. Related to the going concern of the company, auditors are not responsible for assessing the going concern of the company.

These procedures help the auditor gather sufficient appropriate audit evidence to conclude whether the going concern basis of accounting is appropriate in the entity’s particular circumstances. If an auditor is not confident that a business is a going concern, they may issue a qualified opinion. However, before doing so, they will give the company’s management a chance to make a plan to correct the company’s problems and improve its prospects for the future.

It is an important function for a business as it makes it very clear how the business should manage its expenses or commitments to ensure its resources are efficiently managed. High debt levels relative to equity, combined with rising interest costs, can strain financial health. Imminent debt maturities without clear plans for repayment or refinancing are particularly concerning. Credit ratings from agencies like Moody’s or Standard & Poor’s can provide insights into a company’s financial stability. A downgrade in these ratings often signals increased risk for investors and creditors.

What is the role of a financial auditor?

The assumption is that a company, or other entity, will be able to continue operating for a period of time that is sufficient to carry out its commitments, obligations, objectives, and so on. In many ways going concern is one of the most basic and easily understood accounting concepts but it can be quite difficult to apply. Yet, the integrity of the financial statements depends on the accurate application of this concept. The following is guidance from Canadian Accounting Standards for Private Enterprises (ASPE) with regards to going concern.

By contrast, the going concern assumption is the opposite of assuming liquidation, which is defined as the process when a company’s operations are forced to a halt and its assets are sold to willing buyers for cash. Often, management will be incentivized to downplay the risks and focus on its plans to mitigate the conditional events – which is understandable given their duties to uphold the valuation (i.e. share price) of the company – yet the facts must still be disclosed. In addition, management must include commentary regarding its plans on how to alleviate the risks, which are attached in the footnotes section of a company’s 10-Q or 10-K. More specifically, companies are obligated to disclose the risks and potential events that could impede their ability to operate and cause them to undergo liquidation (i.e. be forced out of business). The reason the going concern assumption bears such importance in financial reporting is that it validates the use of historical cost accounting. The Going Concern Assumption is a fundamental principle in accrual accounting, stating that a company will remain operating into the foreseeable future rather than undergo a liquidation.

Suppliers might demand upfront payments or stricter terms, disrupting supply chains. For instance, in cases like Toys “R” Us, supplier relationships often deteriorated before formal insolvency proceedings. My Accounting Course is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. Candidates should generate the audit procedures specifically from information contained in the scenario to demonstrate application skills Jasmine Co in the September/December 2018 Sample exam demonstrates this approach.

Going Concern Assumption

This dynamic is particularly evident in industries like retail, where market shifts can rapidly alter financial stability. In accrual accounting, the financial statements are prepared under the going concern assumption, i.e. the company will remain operating into the foreseeable future, which is formally defined as the next twelve months at a bare minimum. So, when managements consider such an assumption inappropriate, they prepare financial statements using the breakup basis. The breakup basis reports assets based on the amount that is likely to be realized from the sale and liabilities—the net realizable value. For example, seasonal businesses like firecracker companies opt for the breakup basis.

GAAS considers this principle a crucial parameter for determining the longevity of a business. Mike Kiehn is a seasoned writer with a passion for creating informative and engaging content. In fact, a current definition of the going concern assumption can be found in the AICPA Statement on Auditing Standards No. 1 Codification of Auditing Standards and Procedures, Section 341. During economic downturns or crises, external factors like market volatility, regulatory changes, or supply chain disruptions can challenge the assumption of continuity. A retailer values its inventory at cost or net realizable value, assuming it will sell the goods as part of its normal operations.

Management prepares budgets, forecasts, and investment plans assuming the business will continue operating as a going concern. The revenue is recognized gradually over the service period, assuming the business will continue to provide the service throughout the contract term. Under the going concern assumption, the bond is reported as a long-term liability, reflecting the business’s ability to repay it over time. Operational disruptions, such as regulatory changes, technological shifts, or geopolitical tensions, can also threaten viability. For example, changes in trade policies may disrupt supply chains, impacting production and customer fulfillment. Environmental risks, like natural disasters, further compound challenges for businesses without robust contingency plans.

Management needs to incorporate in their assessment based on their knowledge and awareness about what going on in the business. This question is asked mainly when we talk about the roles and responsibilities of management and auditor total cost in economics related to going concerns of the company, and to answer this question, we should refer to the audit standard ISA 570. If the entity’s Financial Statements are prepared in accordance with IFRS, the standard dealing with going concerned is IAS 1.

A. Depreciation of Fixed Assets

The auditor’s review is crucial because it helps lenders, investors, and other stakeholders understand the business’s financial health. If the auditor is satisfied with the business’s financial statements, they’ll give an unqualified opinion, which is a good outcome. The going concern concept assumes that a business will remain operational and continue its activities for the foreseeable allowance for doubtful accounts future. This principle underlies the preparation of financial statements, ensuring assets and liabilities are valued based on their ongoing use rather than liquidation value. The going concern assumption also requires disclosures of financial risks and uncertainties. Companies must provide detailed notes on conditions or events that may raise doubts about their ability to continue operating.

Therefore, the change in value is not realizable; Douglas and his company must not consider the going concern assumption. Cash flow forecasting a small business guide to payroll management is also one of the most important procedures that we should use and perform to assess the going concern problem. – Assume Microsoft is currently suing a small tech company for copyright violation over its software package.

AB Ltd. is a construction company that incurred a loss of $700,000 in a housing project— due to government stay and legal action. As a result, the company missed five installments of debt worth $60,000 (total non-repayment in 5 years).

She is a QuickBooks Online ProAdvisor, LivePlan Expert Advisor, FreshBooks Certified Partner and a Mastery Level Certified Profit First Professional. In 2012, she started Pocket Protector Bookkeeping, a virtual bookkeeping and managerial accounting service for small businesses. And while our site doesn’t feature every company or financial product available on the market, we’re proud that the guidance we offer, the information we provide and the tools we create are objective, independent, straightforward — and free. For instance, the value of fixed assets (PP&E) is recorded at their original historical cost and depreciated over their useful life, i.e. the expected number of years in which the fixed asset will continue to contribute positive economic value. Warning signs include falling market share, poor creditworthiness, employee turnover, low liquidity, lawsuits, excessive business loss, and inability to innovate.

Performance Financial Statements Analysis is an important procedure in assessing the going concern. This analysis includes performing financial ratios analysis, as well as trend analysis. We put environmental analysis in the first point because sometimes most of the management consider mainly the financial problems when performing going concern analysis.