Generally, businesses are set up to operate for a long term and intention of most of the businesses is to expand and be successful in future. This is the basis of going concern assumption which is an important concept of financial accounting and reporting.
As a general rule, financial statements are prepared using going concern assumption, which means that an entity will continue to operate for foreseeable future and will be able to meet its obligations when they fall due. However, reasonableness of this assumption needs to be evaluated in each case. In either of the following two circumstances, the going concern assumption is not valid:
- An entity has planned to wind-up its operations and close the business; or
- Circumstances and financial position of an entity are such that it is not possible for that entity to survive in the foreseeable future.
In such cases, financial statements are not prepared on going concern basis and this fact is disclosed in the financial statements. For instance, an entity which is suffering losses for several years and is facing severe liquidity problems is most likely to be bankrupted and liquidated. In such circumstances, financial statements should be prepared on any basis other than going concern, for example, liquidation accounting basis can be used in which assets are stated at their net realizable values and liabilities are stated at their net settlement values.
Going concern assumption has an impact on how the business transactions are recorded. Certain expenses can be deferred and recorded as prepaid assets if an entity is a going concern. In addition, the concept of classifying assets and liabilities into current and non-current portions is also linked with this principle of going concern.
Importance of going concern and indicators raising doubts on an entity’s ability to continue as a going concern
Practically speaking, it is a very sensitive concept which needs to be looked at from another perspective as well. For instance, if a business is suffering liquidity problems and needs to get financing from a bank, it is very likely that management’s assessment of reasonableness of going concern becomes biased. As the need for financing becomes greater, the bias to report that the entity is a going concern becomes greater as well because banks assess the recoverability prospects of their finance and will not give financing to an entity which is likely to be liquidated. So, in addition to what the management is claiming, users of financial statements can also assess the reasonableness of going concern assumption by reviewing the indicators raising doubts on an entity’s ability to continue as a going concern. Some of these indicators or red flags are given below:
- Significant deterioration of current ratio. Current liabilities are significantly greater than current assets highlighting liquidity issues.
- Capital erosion is also an important indicator which means that an entity is suffering so much loss every year that its accumulated losses are more than its capital.
- Significant litigations or lawsuits against an entity.
- Any change in the laws and regulations governing the licensing of an entity which can result in the entity losing its license to operate.