Going Concern Concept
Going concern concept is a simple but very important financial accounting principle which stipulates the basis on which financial statements are prepared depending on the likelihood of the company continuing its normal course of business.
General purpose financial statements are prepared assuming that the company can and will continue its business in the foreseeable future. If the company is not expected to continue operations i.e. it is required (or reasonably expected) to wind up, its financial statements are prepared using break-up basis. Foreseeable future normally means at least one year.
The assumption that a business is expected to continue in future affects the timing, nature and amount on which accounting transactions are recorded. For example, one criteria for classification of assets and liabilities into current and non-current is whether they are realized/settled within normal course of business. In a non-going concern basis, income, expenses, assets, liabilities and equity are recorded at values that reflect the winding up of business, i.e. assets are recognized at values they are expected to fetch if sold right away, etc.
Management is required to assess at the date of financial statements whether a business is a going concern. Some accounting frameworks require management to disclose their assessment of going concern. Indicators that jeopardize the going concern status of a business include: (a) situation where liabilities exceed assets, (b) default of a loan(s), (c) tax penalties, heavy fines, etc., (d) very adverse regulations, (e) negative cash flows, (f) extremely adverse legal claims, etc.
The auditors of the company are required to analyze the going concern status of a business.
Going concern concept is closely linked with business entity concept, materiality concept and historical cost concept. For example, in assessing going concern, a business is looked at in isolation of its owners, etc. (in line with entity concept); and only material reasons affect the likelihood of continuing operations (in line with materiality concept), etc.
In the following examples, identify if the company should prepare its financial statements on a going concern basis or a non-going concern basis:
- Nigoilia, Inc. is a Nigerian subsidiary of iOil, Inc., a multinational oil and gas firm. Recently the apex court of the country stopped the company from operations in Nigeria.
- National Oil, Inc., a nationalized refinery is facing serious cash flows problems but the government of the country provided a guarantee to the refinery to help it out with all payments.
- A bank is in serious financial trouble and the government is not willing to bail it out. The Board of Directors has passed a resolution to liquidate it.
- IGH, Inc. is in a credit crunch. A creditor demanded payment which the company could not make within 30 days. The creditor has moved the court for liquidation of the company. PQR, Inc. has agreed to bail IGH, Inc. out. The creditor has to withdraw its petition.
- Nigoilia, Inc., the subsidiary must not prepare its financial statements on going concern basis because it can’t continue its operations. Whether iOil, Inc. (the parent company) is a going concern or not depends on the financial hit the parent has suffered due to shutting down of Nigoilia, Inc. Though iOil, Inc. is not directly affected by the judgement, it may not be a going concern if 85% of its investment is in Nigoilia, Inc. However, if the shutdown subsidiary accounted for just 10% of its holdings, the multinational parent can most likely prepare its financial statements on going concern basis.
- Though National Oil, Inc. has severe cash flow problems, it is still a going concern due to backing of the government.
- The bank is not a going concern and must prepare its financial statements on a basis other than going concern because the Board of Directors has decided to liquidate it.
- Though IGH ran into serious trouble, the bail out by PQR has ensured that the company operates in its normal course of business. IGH should prepare its financial statements on going-concern basis.
Written by Obaidullah Jan, ACA, CFA