Assuming a Business Will Continue to Operate Indefinitely
Going Concern Concept: Definition
The concept of going concern states that all records are made on the assumption that the business will continue for the foreseeable future.
Unless it is known that the business will close down at a future time, all transactions are recorded in a routine manner and there is no need for any special valuation or adjustment.
Going Concern Concept: Explanation
Under this concept, it is assumed that the business will operate for a long period of time. When a business is started, it is assumed that it will not be dissolved in the near future.
The financial statements (i.e., profit and loss account and balance sheet) are also prepared under this assumption, as this concept leads to a distinction being made between capital and revenue expenditures.
Here, it should also be noted that the assumption is not made that the business will be profitable throughout its existence.
As this concept relates to the future, which is inherently unpredictable, several factors can be used to determine whether a business is a going concern. These include:
- Strong capital structure
- Ability to overcome short-term risk
- Possession of reasonable liquid assets
- Continuous demand for products
However, if it is known that a business will close down in, for example, the next two or three months, it would be more appropriate to state its assets not at cost but at the value at which these can be sold on the closure of the business.
At this stage, it may also be necessary to take account of all legal obligations that may not have been previously brought to books.
Unless it is categorically stated otherwise, all accounting records and income statements or balance sheets are prepared on the assumption that the business will continue to function for an indefinite future period.
The laws that bind corporations in all countries state that a company is presumed to have an uninterrupted existence with continuing activity until such time as it is legally liquidated.
If the results of the operations of the business enterprise were to be accounted for based on expected liquidation, it would be impossible for suppliers to supply goods and services, for employees to offer their services, and for other businesses to transact with the business entity.
For this reason, for purposes of accounting, business enterprises are presumed to carry on their operations indefinitely until such time as they are in fact liquidated.
A corollary to the going concern concept is the assumption that a business enterprise will not be liquidated within the foreseeable future.
This is because it would make it impossible for the business to carry out its present contractual commitments or to use its resources according to a predetermined plan of operation.
The going concern concept is best summarized as follows:
The enterprise is normally viewed as a going concern, that is, as continuing in operation for the foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially the scale of its operations.
Examples
Example 1
An organization produces a compound called Chemical X. Unexpectedly, the federal government imposes a limitation on the production, export, import, sale, and marketing of this compound in the country.
Given these circumstances, if Chemical X is the only product the company produces, the business will no longer be classified as a going concern.
Example 2
The National Company has fallen into serious financial problems and cannot cover its duties. Due to this, the federal government provides the company with a bailout package and also a guarantee to clear all its credit payments.
Regardless of its weak financial standing, the National Company is still considered a going concern.
Example 3
The Eastern Company has closed a division but will continue working in its other divisions as usual. The business is a going concern because the closing down of a small portion of business does not impair the capacity of the enterprise to continue indefinitely in the future.
Example 4
A small business cannot make payments to its creditors due to an extremely poor liquidity position. The court grants the purchase price of liquidating the company upon the petition of one of the firm's creditors.
The business is not a going concern as, according to the available evidence, it will not be able to continue its operations for a long time in the future.
Frequently Asked Questions
Is the concept of going concern justifiable?
Yes. It is not possible to close down a business permanently at one go. This would be against the law in most countries, and it makes no sense. This concept helps legal entities to continue with their operations in a more or less smooth manner without any serious hassles due to sudden litigation or liquidation.
Is there any way to calculate goodwill?
The calculation of goodwill takes into account the fair value of the net assets acquired less any adjustments for purchase price, encumbrances or unusual conditions that will not affect the future operations.
What if a business has permanently closed down?
If a business has permanently closed down, the assets should be removed from the books and all liabilities are settled. If there are still some assets that are still in use, these must be transferred to the new owner or sold with appropriate adjustments.
Can you give an example of when it's better to use going concern?
When using the going concern method, businesses can step up to their profits or losses by transfers to equity account. If the net income is zero or negative, it may be better for a company not to report any figures at all. This will help prevent the investors from getting pessimistic forecasts about future losses.
What does goodwill refer to?
Goodwill refers to the value of an acquired company which exceeds its purchase price. It can also be referred to as intangible assets like patents, copyrights, licenses and trademarks.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.
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Source: https://learn.financestrategists.com/explanation/accounting-concepts-and-principles/going-concern-concept/
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