The going concern accounting principle is an indispensable concept in the world of accounting, serving as an essential element that facilitates the production of dependable financial statements that present an accurate depiction of an entity’s financial state and operations. This article endeavors to delve deeper into the going concern accounting principle, elucidating its significance and application to small businesses.
Table of Contents
1. The Going Concern Principle
2. Accounting Implications of the Continuity Assumption
3. Understanding of going concern principle
4. Example of going concern
5. Signs of Potential Going Concern Issues
6. Conclusion
7. FAQs
The Going Concern Principle
The going concern concept is a fundamental principle in accounting, which presupposes that an entity will continue to operate for the foreseeable future, and its assets will be held for use in generating revenue, rather than for disposal. As a result, fixed assets, being an integral part of the production process in a manufacturing unit, are not reflected in their current resale value.
However, in the event of an entity’s imminent liquidation with compelling evidence to support such an outcome, the assets should be recognized at their liquidation value, and the liabilities should be recorded at the amount required for immediate settlement. This approach ensures that the financial statements accurately reflect the entity’s financial position and aids stakeholders in making informed decisions regarding the entity’s future.
Accounting Implications of the Continuity Assumption
As per the continuity assumption, certain accounting implications arise, namely:
The demarcation between capital expenditures and revenue expenditures.
The categorization of assets as current or non-current, and liabilities as current or non-current.
The procurement of fixed assets is for operational use, and not intended for sale in the regular course of business.
The systematic allocation of depreciable assets’ cost over their useful lives.
Fixed assets’ liquidation value is not depicted in the Balance Sheet.
Understanding of going concern principle
In accordance with the going concern principle, accounting professionals exercise their judgment to determine the appropriate financial reporting to be presented in financial statements. In the case of businesses that are still operating, long-term assets may be recorded at their cost rather than at current or liquidation value. However, if the sale of assets does not impede a company’s ability to conduct business, such as in the case of closing a small branch office and relocating the staff to other business divisions, the business is still deemed to be a going concern.
Accountants who apply the going concern principle generally believe that the business utilizes its assets prudently and has no immediate need to liquidate them. Based on this principle, accountants can advise businesses on asset sales, cost-cutting measures, or transitioning to different products.
It should be noted that while the going concern principle is covered in generally accepted auditing standards (GAAS), it is not part of generally accepted accounting principles (GAAP).
Example of going concern
The local grocery store has demonstrated a successful track record of over 20 years, evidenced by a continuous stream of satisfied customers and sustained profitability. The owner anticipates continued financial stability for the store, based on its historical performance and present financial position. This has enabled the owner to secure financing from a bank for the purchase of new merchandise, essential business repairs and modifications, and the hiring of additional employees. The bank has extended this loan on the premise that the store is a going concern that will generate sufficient cash flows to meet its debt obligations.
However, businesses must adhere to the going concern principle in accounting, as failing to do so may lead to dire consequences. Ignoring potential insolvency indicators or inaccurately assessing a company’s ability to continue operating can result in a distorted representation of financial health, eroding investor confidence, and ultimately resulting in bankruptcy. It is therefore vital for businesses to recognize the significance of the going concern principle and ensure its proper implementation to avoid such catastrophic outcomes.
Signs of Potential Going Concern Issues
Employee turnover
Poor liquidity ratios
Legal and regulatory matters (including recurring trading losses, loss of patent, and non-repayment of loans)
High debt levels
Negative cash flow
Weak management
Economic downturns
Dependence on key customers or suppliers
Technological obsolescence
Litigation and insurance claims.
It is important to note that these indicators are not necessarily conclusive on their own, but rather serve as warning signs that the company may be facing financial difficulties. Companies should regularly monitor their financial performance and address issues as soon as possible to avoid potential insolvency.
Conclusion
The principle of going concern serves as a vital tool for small firms as it aids in the establishment of a sound financial footing, and access to funding and curtails the possibility of financial misrepresentation that may culminate in insolvency. With 22 years of experience in bookkeeping and outsourced accounting services, the skilled professionals at IBN Tech are well-equipped to assist your small business in maintaining a precise and trustworthy accounting system.
Faq
- Q.1 Why is the going concern principle important?
- The going concern principle holds significant importance in accounting as it enables businesses to assess their assets and liabilities with precision. Without the going concern principle, businesses would have to revalue their assets and liabilities each reporting period, which would be time-consuming and difficult.
- Q.2 What are some indications that a business may not be a going concern?
- Some indications that a business may not be a going concern include inadequate capital, declining sales, consistently operating at a loss, insufficient cash flow to meet obligations, and a high debt-to-equity ratio.
- Q.3 What steps can a business take become a going concern again?
- Steps a business can take to become a going concern again include increasing capital, improving cash flow, reducing debt, and improving operational efficiency.
