Going concern assumption

Going concern assumption – Going concern is one the fundamental assumptions in accounting on the basis of which financial statements are prepared.

IAS 1 states “When preparing financial statements, management shall make an assessment of an entity’s ability to continue as a going concern. An entity shall prepare financial statements on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. When an entity does not prepare financial statements on a going concern basis, it shall disclose that fact, together with the basis on which it prepared the financial statements and the reason why the entity is not regarded as a going concern” (IAS 1 25).Going concern assumption

IAS 1 appears then to suggest that a departure from the going concern basis is required when the specified circumstances exist. Going concern assumption

This is confirmed by IAS 10 which states that “an entity shall not prepare its financial statements on a going concern basis if management determines after the reporting period date either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so.”(IAS 10 14). Going concern assumption

Neither IAS 1 nor IAS 10 provide any details however of any alternative basis and how it might differ from the going concern basis. Management should then choose accounting policies that will result in the most relevant and reliable financial information. Going concern assumption

Entities will therefore need to give careful consideration as to the appropriate basis of preparation bearing in mind their own specific circumstances. The purpose here is not to provide guidance on determining whether an entity is or is not a going concern but to provide insights on the matters to be considered when a going concern basis is not appropriate. Going concern assumption

Financial statements not prepared on a going concern basis

Several points are relevant to the objective of financial statements that are not prepared on a going concern basis. Going concern assumption

Firstly, there is no general dispensation from the measurement, recognition and disclosure requirements of IFRS if the entity is not expected to continue as a going concern. But it seems logical to use the ‘normal’ recognition and measurement requirements of IFRS as the starting point for accounting and only deviate from these where adequate justification exists, for example arising from events after the reporting date or impairment testing of assets.

Something else -   Reporting entity

A second point is that each situation needs to be assessed on its own facts and circumstances as some entities in a non-going concern situation will be closer to liquidation or ceasing trading than others. The accounting will typically reflect this. For example, when an entity is in the process of being liquidated or will be liquidated imminently, the financial statements might be prepared under what is sometimes referred to as a ‘break-up basis’ or ‘liquidation basis’.

Some argue that under such a ‘break up’ basis, the objective of the financial statements changes from reporting financial performance to consideration of matters such as:

  • whether the assets are sufficient to satisfy the entity’s creditors
  • quantification of the amount of any surplus that may be available for distribution to the shareholders (ie what the value of the entity will be when it is ‘broken up’ into its separate parts on liquidation).

This is important as under such a ‘break-up basis’, provision would be made for losses subsequent to the reporting period and for the costs of winding up the business irrespective of whether an irrevocable decision to terminate the business had been made at the end of the reporting period. Assets would also be restated to their actual or estimated sale proceeds even if this was different from their fair value at the end of the reporting period.

In general it makes sense to consider these changes in the objective of the financial statements while preparing such financial statements.

Writing down assets

It will always be appropriate to consider the need to write down assets for impairment when a company intends to liquidate the entity or to cease trading. For instance, when financial statements are prepared on a going concern basis, a non-financial asset may be stated at an amount which is greater than its (short-term) net realisable value provided that it is no greater than its (longer-term) recoverable amount.

Going concern problems indicatorsGoing concern assumption

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.
Something else -   The Role of Financial Reporting

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.

The going concern concept or going concern assumption states that businesses should be treated as if they will continue to operate indefinitely or at least long enough to accomplish their objectives. In other words, the going concern concept assumes that businesses will have a long life and not close or be sold in the immediate future. Companies that are expected to continue are said to be a going concern. Companies that are expected to close in the near future are not a going concern.

The going concern concept is extremely important to generally accepted accounting principles. Without the going concern assumption, companies wouldn’t have the ability to prepay or accrue expenses. If we didn’t assume companies would keep operating, why would be prepay or accrue anything? The company might not be there long enough to realize the future expenses.

One of the most significant contributions that the going concern makes to GAAP is in the area of assets. The entire concept of depreciating and amortising assets is based on the idea that businesses will continue to operate well into the future. Assets are also reported on the balance sheet at historical costs because of the going concern assumption. If we disregard the going concern and assume the business could be closed within the next year, a liquidation approach to valuing assets would be more appropriate. Assets would be recorded at net realizable values and all assets would be considered current assets rather than being segregated into current and long-term categories.

Something else -   Purpose of related party disclosures

Some businesses, however, do close and do go bankrupt. If the business is in a financial position that suggests the going concern assumption can’t be followed (the business might go bankrupt), the financial statements should have a disclosure discussing the going concern.

Examples

Going concern assumption

– In the early 2000s, General Motors was experiencing great financial difficulties and was ready to declare bankruptcy and close operations all over the world. The Federal government stepped in and gave GM a bailout as well as a guarantee. In normal circumstances, GM would not be considered a going concern, but since the Federal government stepped in, we have no reason to believe that GM will cease to operate.

– Assume Microsoft is currently suing a small tech company for copyright violation over its software package. Since this software package is the only operation the small tech company does, losing this lawsuit would be detrimental. There is a 95 percent expectation that Microsoft will win the lawsuit. The small tech company is not a going concern because it is probable they will be out of business after the lawsuit is settled.

– In 2011, Gibson Guitar Factory was raided by the Federal government for illegally smuggling endangered wood into the country. The Federal government took more than $250,000 worth or Gibson’s inventory and slapped them with large fines for violating international laws. Gibson is still considered a going concern, because it is not likely the fines and punishment will stop its operations.

and one more bankruptcy (Enron) and another storyline, same subject.

Going concern assumption

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Something else -   Deferred tax assets Future tax profits

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