What is the Going Concern Assumption?
Definition: The going concern assumption is an accounting principle that states a business should be viewed as if it will continue to operate into the future.
When a business opens its doors to the public, the common assumption is that it will remain open for the longest time possible, including in the foreseeable future. In financial accounting, this concept is referred to as the going concern assumption. Its application means that entities should operate without the fear of insolvency. Hence, there must be a declaration of keeping the operations going for at least 12 months.
That said, the continuity of the business means that the business can easily adhere to its financial obligations, including the drawing of financial statements. Meanwhile, these can only be prepared when they are due. By then, an external auditor has already determined whether or not the business is a going concern.
Going Concern Principle Explained
When a business chooses the going concern principle, it merely means that it has the potential to earn profits. However, it must operate under the generally accepted auditing standards (GAAS), which the auditors use to consider the ability of business continuing to operate under the going concern principle.
How big should be the business to be subjected to the going concern principle? There has been a misconception that only the publicly traded business should adhere to the going concern. It is not true because every business, despite its size, is somewhat wedged under the going concern assumption.
Importance of the Going Concern Concept
It is practically essential to understand this GAAP assumption and its implications before opening your business. It is primarily an assessment of the overall viability of your business. Here are some of the reasons why small business owners continue to have deep conversations and concern as to why their businesses will pay attention to the going concern assumption: –
- It is the only way to demonstrate its sustainability to the stakeholders and investors who keep the businesses running. It would perhaps give them a conviction of raising capital or seek other investors when such need arises.
- It is important to regulators, and the watchdogs who ensure the financial reporting is done using the right policies and procedures. Every business has the mandate of preparing financial statements within a specific time.
- Lenders are likely to use the going concern concept in determining whether or not the business qualifies for any long-term financing. And in case of any doubts on this, the financial institutions retreat.
Going Concern Assumption Example
Every business aims to remain in operation for an indefinite time, hence the high energy at the starting point. However, there are instances whereby the business may fall victim to being unable to meet its financial obligations. It can easily be detected from the business’s financial statements and could push investors into selling their shares.
In this regard, the going concern concept may not apply, and here are some of the warning signs any business can look out for: –
- When lenders present low evidence about the businesses’ inability to service its loan obligations could be a warning sign.
- When businesses are forced to discount their services or products to make ends meet, it implies that it is in trouble and cannot meet its financial obligations.
- A majority of businesses tend to fall under the trap of past-due accounts payable, and if they surpass 90 days, the business is likely to be heading to a liquidation.
- If the relationship between current assets and liabilities (current ratio) is less than 1 is a clear indicator that the business is struggling financially.
However, business owners can choose to reverse the warning signs by taking appropriate actions which include:
- Addition of contributions by shareholders
- Restructuring the debts to avoid insolvency of companies perhaps by selling some assets to repay.
- Reducing expenses to increase cash flow and improve the company’s profitability position.