The Principle of Going Concern
The going concern principle is the fundamental accounting principle that assumes that a business (entity) is financially sound enough so that it will remain operational in the foreseeable future. In other words, it is the assumption that an entity will remain in business for the foreseeable future.
Put the other way, this means the entity will not be forced to halt operations and liquidate its assets in the near term at forced, low prices. By making this assumption, the company's accountant is justified in deferring the recognition of certain expenses until a later period, when the entity will presumably still be in business and using its assets in the most effective manner possible.
According to this principle, every business will operate and make its business decisions based on continuing business in the foreseeable future (except in some cases of time-specific companies such as a joint venture for a project). According to IAS-1, "foreseeable future" is: until the end of the 12 months period from the end of the current reporting time period. The principle requires managers and auditors to prepare financial statements by applying a going concern assumption.
This underlying principle is also known as the "continuing concern concept
Examples of applying the "going concern concept" could be: prepaid expenses, recording of long-term assets at cost, and deferred income taxes and profits.
In simple words, the going concern basis of accounting is an assumption that the business will operate and complete its current business plans during the next, upcoming fiscal years by utilizing its current assets and fulfilling its business obligations rather than having an intention or a need to liquidate the business.
The Financial Accounting Standards Board (FASB) documented the concept of going concern in its first standard IAS-1 (Presentation of Financial Statements), but the concept is NOT defined in the Generally Accepted Accounting Principles (US GAAP)
guidelines. The FASB standard requires the company to prepare financial statements based on going concern assumption and accrual accounting
. It also requires the company to disclose if the ability of a company to run as a going concern is uncertain.
According to the ISA (International Standard on Auditing) 570 provision, it is the responsibility of the auditor to apply the going concern basis of accounting during the audit. In the paragraph 23 and 24 of IAS 1 (Preparation of financial statements), during the preparation of financial statements, management shall (must) conduct a thorough assessment of the entity's ability to continue as a going concern.
Conditions for going concern concept
There are three conditions prescribed in the ISA 570 outlines for assessing an entity's ability for using going concern basis of accounting:
1. Assessment of nature, size, complexity and condition of business entity in accordance with the external factors and its effect on the judgments of outcomes.
2. Judgments for future are made on the basis of current available information. Assessment of consistency of these judgments and their subsequent realistic outcomes.
3. Assessment of current condition or events and their subsequent outcomes on the future event or conditions.
Appropriate use of going concern basis of accounting
Assume that ABC Company closes its "Product 2" from its product portfolio because the product 2 is yielding losses and is unable to cover its cost. The company will continue its operations after closing its one product by applying going concern basis of accounting.
Here, application of going concern basis of accounting is appropriate, because the going concern concept is applicable for a business as a whole, and not in particular for a single product or some business segment.
Another example is the computation of depreciation
on the basis of economic life of assets which fulfills the concept of going concern in that the asset will be used until fully depreciated and the business will continue to operate for an indefinite time period.
Inappropriate use of going concern basis of accounting
Assume that ABC Company has borrowings of €5000 which is repayable on 31st of December 2020 fully. The company is breaching its contract by exceeding the agreed value (of €5000) or due date. The bank refuses to increase or renew the borrowings and announces to commence a legal proceeding against the company to pay off its borrowings. Moreover, ABC Company has no ability to apply for other re-financing or renewing borrowings options. Thus, this is a situation where the company should cease its business operations and apply for a liquidation process. Despite this, management prepared financial statements on the going concern basis of accounting and refuses to add disclosures in order to avoid any further decline in its credit rating.
Here, an application of going concern basis of accounting is inappropriate, because management have no other realistic alternative but to liquidate.
"IAS-1 Presentation of Financial statements", IAS Plus.
Technical Article: "Going Concern" by ACCA Think Ahead.
"IASB publishes 13 revised IAS", 19 Dec 2003.