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Going concern assumption

Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.

Possible indications of going concern problems are:

  • Deteriorating liquidity position of a company not backed by sufficient financing arrangements.
  • High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.
  • Significant trading losses being incurred for several years. Profitability of a company is essential for its survival in the long term.
  • Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.
  • Increasing level of short term borrowing and overdraft not supported by increase in business.
  • Inability of the company to maintain liquidity ratios as defined in the loan covenants.
  • Serious litigations faced by a company which does not have the financial strength to pay the possible settlement.
  • Inability of a company to develop a new range of commercially successful products. Innovation is often said to be the key to the long-term stability of any company.
  • Bankruptcy of a major customer of the company.

If the going concern assumption is considered to have become invalid, the basis of accounting for the preparation of the financial statements is dramatically different.

It means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business. Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled.

See below on almost going out of business (General Motors) and one bankcruptcy (Enron):

https://en.wikipedia.org/wiki/Enron_scandal

 

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