What is a Going Concern?

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.

It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This 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.

What are possible indications of going concern problems?

• Deteriorating liquidity position of a company not backed by sufficient financing arrangements.
• 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.

Examples

(1). A company manufactures a chemical known as Chemical-X. Suddenly, the government imposes a restriction on the manufacture, import, export, marketing and sale of this chemical in the country. If Chemical-X is the only product that company manufactures, the company will no longer be a going concern.

(2). The National company is in serious financial trouble and cannot pay its obligations. The government gives National company a bailout and a guarantee of all payments to creditors. The national company is a going concern despite of its current weak financial position.

(3). The Eastern company closes one of its branch and will continue with others. The company is a going concern because the shutting down a small part of business does not impair the ability of the company to operate as going concern.

(4). The Small company is unable to make payments to its creditors due to a very weak liquidity position. The court grants the order of liquidating the company upon the request of one of the company’s creditors. The company is no longer a going concern because sufficient evidence is available to believe that the company cannot continue its operations in future.