Entity is considered a going concern if it is considered capable of continuing its operation for the foreseeable future and is not expected to go out of business unless an evidence proves otherwise.
In simple words entity is a going concern if it is expected to:
- remain capable to carry out its routine business activities i.e. use and consume its assets for the intended purpose i.e. extract their utility by using them to convert raw material or provide intended services,
- can plan activities and implement them,
- pay its obligations at the agreed time.
Going concern concept is also called continuing concern concept.
Whether entity is a going concern or not is judged by analyzing the likelihood and significance of factors and situations that can compromise entity’s abilities to continue its activities.
An entity that is losing or no longer a going concern can recover if it can take safeguarding steps in time to avoid circumstances that are threatening its existence. The ultimate effect of ceasing to be a going concern is bankruptcy.
An entity is, by default, assumed to be a going concern unless and until there is a reason, evidence or indicators that negates such assumption. That is why going concern is a fundamental assumption while preparing financial statements under GAAP and IFRSs. It is the duty of entity’s accountant or management to interpret the circumstances that are indicative of going concern problems. Such indicators include:
- Inability to continue business operations because of court or government order. For example a specific raw material that is used by entity is now banned.
- Current line of product is redundant and are no longer in demand.
- Unable to replace important non-current assets that are either expired or near the end of their useful life.
- Increased reliance on short term borrowings to cover non-developmental expenses.
- Declining operational profits indicating inefficient management and leaving lesser room for present and future borrowing costs to cover.
- Entity engaged or planning to engage in contracts resulting in substantially high financial gearing. This can result in credit denial.
- Ongoing litigation that entity is expected to lose resulting in entity unable to continue for example; significant penalty that entity can’t pay, cessation of its operation or assets etc.
- A customer who owes significant amount of money is expected to go bankrupt causing disruption in entity’s cash inflows. Or a supplier of raw material entity uses to manufacture its products is expected to shut down and entity has no alternative for raw material.
If this fundamental assumption fails then entity has to prepare financial statements in the light of provisions applicable to it in the respective jurisdiction. GAAP and IFRSs does not apply if entity cease to be a going concern. Usual practice is that entity’s assets are measured at values they can immediately fetch that can be significantly lower than historical cost and current fair value of asset. Also liabilities are reported on immediate settlement basis which can be higher than initially agreed amount.
- XYZ extracts oil from natural fruits and seeds. In 2008 earthquake devastated the industrial zone in which it operates destroying silos. In absence of control storage environment for both raw material and finished goods, XYZ cannot resume its production casting severe going concern problem. Government however, recently announced a bail out plan for entire industrial zone and it is expected 70% of silos cost will be paid by government. XYZ can raise more funds by discounting receivables as its customers are spread across the country. Because of bailout package, entity is a going concern.
- ABC refines natural oil. Because it is in close proximity to residential area, court ordered to shut down refinery completely immediately. ABC directors have already moved to file an appeal in higher court to give enough time that they can move the plant elsewhere. For now entity has enough resources to pay its liabilities and minimum managerial staff for moths to come. ABC is still a going concern although its operations are on halt. Situation may worsen if shut down persists for a longer period of time while cash assets deplete.
- In May 2018, Samsung was slammed with half a billion dollars fine for violating Apple copyrights. Despite a hefty amount Samsung is still a going concern with strong financial position.
- JKL is facing a lawsuit for recent fire that resulted in multiple casualties. Petitioner held JKL responsible for gross negligence for not designing the building safe and ignoring to install proper fire hydrant system. It is expected that JKL will face heavy penalties as court has decided to announce verdict within 90 days. JKL is not a going concern and financial statements must be prepared on settlement basis.
- MNO extracts natural oil with process called “fracking” short for “hydraulic fracturing”. Lately MNO has faced an outcry that process employed by entity is disturbing rock bed which can lead to natural calamity as well underground water table. Pressure groups have managed to move government against MNO and government has banned the fracking process. MNO relies solely on fracking and it is extremely difficult for it to switch to drill process, MNO’s board of directors has decided to voluntarily wind up thus MNO no longer a going concern.