What is the Going Concern Principle?

Going Concern Principle

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Going Concern Principle

The going concern principle is an accounting concept that assumes a business will continue to operate indefinitely, or at least for the foreseeable future, which is typically the next 12 months. This means it will remain in business long enough to carry out its obligations and achieve its objectives.

This assumption is fundamental to financial reporting because it justifies the use of historical cost accounting. For example, assets are recorded at their original cost and depreciated over their useful life, liabilities are not accelerated, etc. Without the going concern assumption, businesses would need to evaluate and report asset values as if they were to be liquidated, which can have a significant impact on the reported financial position of the company.

If there is evidence that the business may not be able to continue as a going concern, it can cast doubt on the validity of this assumption. Such evidence might include a series of operating losses, negative cash flows, legal troubles, or a significant downturn in its operating environment.

In such a case, both management and the independent auditor have a responsibility to evaluate these conditions. If there is substantial doubt about the entity’s ability to continue as a going concern, this needs to be disclosed in the footnotes of the financial statements, and the auditor’s report will also contain a statement about this uncertainty.

Example of Going Concern Principle

Let’s consider a hypothetical company, “Alpha Manufacturing Inc.,” that makes specialized machinery.

In normal circumstances, when preparing their financial statements, Alpha Manufacturing Inc. follows the going concern principle. This means the company assumes it will continue its operations for the foreseeable future (generally at least the next 12 months). Under this assumption, it records assets at their cost and depreciates them over their expected useful lives, it plans to fulfill its liabilities in the normal course of business, and it doesn’t plan to liquidate or drastically curtail its operations.

Now, suppose Alpha Manufacturing Inc. experiences a series of setbacks. There are consistent operating losses, a significant decrease in market demand for its products, and an inability to secure additional financing. These factors cause both the management and the auditors to have substantial doubts about the company’s ability to continue as a going concern.

In this situation, Alpha Manufacturing Inc. must disclose this uncertainty in the notes to its financial statements. The disclosure might describe the conditions causing the concern (operating losses, decreased demand, lack of financing), the possible effects (inability to meet obligations, potential bankruptcy), and any plans to mitigate these effects (new financing arrangements, cost reductions, etc.).

In addition, the auditors of Alpha Manufacturing Inc. would include a paragraph in their audit report stating that there’s substantial doubt about the company’s ability to continue as a going concern. This would serve as a warning to users of the financial statements about the company’s precarious situation.

This is a simplified example and in real life, these situations can be much more complex, with a variety of factors affecting the going concern assessment. Any such decisions should be made in consultation with financial advisors or accountants, who can take into account the specifics of the situation and the applicable accounting and auditing standards.

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