Going Concern

What is Going Concern concept in Accounting?

The concept of Going Concern refers to the continuity assumption that is made when building the accounting statements. It is expected that the company will carry on the operations and the business will not shut down in the near future.

When the Going Concern assumption is considered, less importance will be given to the current Market Value or Liquidation Value of an asset. This is because the assets are expected to be utilized for their entire life and they would not be liquidated in the near future.

So, this forms the basis for the business to accumulate value from the resources that are utilized continuously. And all unused or partially used assets can be reported at their cost of acquisition and not their current value.

Going Concern accounting principles

The Going Concern concept is the basic assumption that has to be made when applying Depreciation in the accounting statements. For long-term assets like machinery, equipment, building, vehicles etc., charging the entire cost in 1 accounting period can cause a sudden change in the profits, on a Quarter-on-Quarter basis.

Depreciation allows the company to split the cost and charge a portion of it in different accounting periods. For example, a company might follow Straight Line Depreciation at the rate of 10 %. So, if a machine is acquired for INR 5 lakh (INR 5,00,000), then an annual charge of INR 50,000 (10 % of INR 5 lakh) will be created for 10 years in the statements.

Without the Going Concern assumption, we cannot split the costs over many years in the future. This is because the business could shut down operations and the costs have to be fully charged in the statements, before the Liquidation Date.

Periodic Reporting

If the business is expected to continue operations for a long duration, then the cost can be charged over an extended duration. But it is not practical to report the financials at the end when the asset has completed its useful life after many years.

So, a closely linked concept to Going Concern is the Periodicity Concept in accounting. Based on the Periodicity assumption, the entire life of the company is broken down into smaller Accounting Periods.

Since the business is expected to continue for many years, it becomes logical to frequently report the financial performance at the end of these Accounting Periods. Regular reporting of financials will ensure that all the stakeholders are aware of the operations. This can also help in easy measurement and comparison of the financials on a Year-on-Year basis.

Going Concern Example

Suppose that a company generates revenue of INR 2 crore (INR 2,00,00,000) this year. Also, this year it has paid a rent of INR 60 lakh (INR 60,00,000), and it has bought a machine worth INR 70 lakh, which has a useful life of 5 years.

Without the assumption that the business will operate for a long duration, a company would need to create an expense of INR 1.3 crore (INR 60 lakh + 70 lakh) in this Financial Year. This might not give a true picture because the useful life of the machine is 5 years. So, it might make sense to split the expense for the machine over a 5-year period.

But, before we can split the Capital Expenses like this, an assumption has to be made that the business will operate for the next 5 years. So, if a business is a Going Concern, then it is expected to continue operations for a long time.

After making this assumption, the Capital Expense of purchasing the machine will be INR 14 lakh (INR 70 lakh / 5) for this Financial Year (using the Straight-Line Depreciation method). Similarly, INR 14 lakh will be charged again in the statements, for the next 4 Financial Years.

Need for Going Concern principle

Suppose that a business is started with the expectation that it will operate for only 1 year and will be liquidated at the end. In this case, the company will make all investment and expense decisions based on a short time horizon.

As explained in the above example, the method of charging the expenses and the revenue will also change. The accounting statements will have to be prepared and reported differently, and the company might face issues when raising capital/investment.

By default, it is assumed that the business will indefinitely operate on a Going Concern basis unless there is a strong possibility of closing the operations in the near future. This helps in proper Capital Structure planning and making investments over a long-term horizon. The growth and predictability of the financials will also be smoother across the time periods.

Problems without Going Concern

When a Going Concern Audit is being done, the Auditor tries to analyze if the company will be able to meet its obligations for at least 1 year in the future. If a business is likely to face financial difficulties, it might be hard for the business to borrow funds or raise money from investors. Moreover, the business might have problems in procuring raw materials from suppliers.

If a firm is not a Going Concern, then it means that the business has gone bankrupt or that it could be liquidated soon. So, the assets and liabilities, in this case, should be priced in the Balance Sheet at the Liquidation Value or the current Market Value.

This will cause the reported financials and profits to swing rapidly over the different quarters. And this negatively impacts the stability of the accounting process because the Fair Value Measurement (FVM) will generate different values.

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