What is the Going Concern Concept in Accounting?
Going Concern Concept Definition
In short, going concern refers to a business’s ability to continue operating in the near future, usually for at least the next year.
In other words, the going concern concept assumes that a business will be able to meet its financial obligations, pay its debts, and operate normally for the foreseeable future.
This is an essential concept for companies, investors, and lenders alike, as it can affect financial reporting, decision-making, and the long-term success and sustainability of the business.
The Going Concern Assumption in Financial Reporting
The going concern assumption is a fundamental concept when companies report their financial results in their financial statements.
This assumption affects how financial statements are prepared and presented, as it assumes that the business will be able to continue functioning and performing as expected.
If a business is not considered a going concern, it must use a different set of accounting principles, which can lead to adjustments in the financial statements.
For example, if a business is no longer expected to operate for the next year and cannot be considered a going concern, it must prepare its financial statements differently.
Instead of assuming that the business will keep operating, the financial statements will need to reflect the value of the business’s assets if they were sold off, which is called their liquidation value.
For example, let’s say a company that manufactures skateboards is struggling to stay in business, and is expected to shut down within the next few months.
If the company was a going concern, they would report the value of their skateboards based on what they could sell for over the next year.
However, since it’s not a going concern, it must report the value of their skateboards based on what they could sell for immediately.
The reason for this is if the company is not able to continue operating, they must liquidate their assets to pay their debts and return money to their investors.
Reporting the liquidation value of assets can significantly impact the financial statements of a company that is not a going concern.
This is because the value of the assets may be lower if they are sold quickly rather than over time, as they would be if the company was expected to continue operating.
This can make the company’s financial position look worse and can affect its ability to attract investors or secure loans.
Evaluating a Company's Going Concern Status
Assessing a company’s going concern status involves looking at several factors to determine whether it is likely to continue operating in the near future.
Some of the key factors include:
Financial Performance
This refers to how well the company is performing financially, such as its profitability and revenue growth. If a company is consistently losing money or failing to generate enough revenue to cover its expenses, it may struggle to continue operating in the long term.
Cash Flow
Cash flow is the amount of cash that comes in and goes out of the company. If a company is experiencing negative cash flow, meaning it is spending more than it is earning, it may struggle to pay its bills and meet its financial obligations in the near future.
Liquidity
Liquidity refers to the company’s ability to convert its assets into cash quickly, without incurring significant losses. If a company has poor liquidity, it may struggle to pay its bills or obtain financing when it needs it.
Ability to Obtain Financing or Access Capital Markets
If a company is unable to obtain financing from banks or investors, it may struggle to continue operating. Similarly, if a company is unable to access capital markets to issue debt or equity, it may have difficulty raising the funds it needs to operate.
One of the main indicators of potential going concern issues is a company’s inability to meet its financial obligations when they become due.
This could include missed loan payments, unpaid bills, or an inability to pay employee salaries.
If a company’s going concern status is in doubt, it’s important for them to take action to address the fundamental issues.
This could involve developing a plan to improve cash flow, renegotiating debt or lease agreements, or seeking additional financing.
In some drastic cases, it may be necessary to consider restructuring or selling the business.
How Going Concern Affects Different Stakeholders
The going concern status of a business can have significant impacts on different stakeholders, including shareholders, creditors, and employees.
Shareholders
For shareholders, a positive going concern status usually demonstrates that the business is stable and likely to continue generating profits in the future.
This can help maintain or increase the value of their investments.
On the other hand, if a company’s going concern status is in doubt, shareholders may see a decline in the value of their investments, as well as a potential decrease in dividends or other distributions.
Creditors
For creditors, the going concern status is an important consideration when assessing the creditworthiness of a business.
If a lender is considering lending money to the business, they may be more willing to extend credit or offer more favourable terms.
In contrast, if a company’s going concern status is in doubt, lenders may be less willing to even offer a loan or might demand higher interest rates to compensate for the increased risk.
Employees
For employees, a healthy going concern status generally indicates job security and the ability to continue receiving salaries and benefits.
On the other hand, if a company’s going concern status is in doubt, employees may face uncertainty about their future employment and may be more likely to seek opportunities elsewhere.