The going concern concept states that, from a financial reporting perspective, a business should be seen as an entity that will continue to operate for a long period. A corporation is seen as an artificial person, therefore, its activities are legally binding in the court of law. Also, it is expected that the business will outlive its founders.
What should you know?
The principle of going concern explains the continuity ability of a business. As artificial beings, companies are expected to continue existing for a long period. When a business fails suddenly and will liquidate within the next year, this principle does not apply.
Financial statements are prepared based on these principles. Also, the historical cost measurement for items of property, plant, and equipment is due to the belief that the entity will continue. More so, revenue can be deferred, expenses prepaid, or advanced due to the going concern concept.
When a business will not continue to exist, then it will become insolvent and thereby be liquidated. In this situation, the breakup or liquidation basis is used for measurement. In this case, the value of the company assets and liabilities is recorded at their fair value less selling expenses.
Going concern and external auditors
Auditing standards explain that an external auditor must examine the going concern of a company under audit and should provide a report about it. Auditors do check if a company will continue within the next year of the financial statements under audit.
In doing so, they check for information within and outside the entity. Things like whether the company has continued to make losses over time, the threat of bankruptcy from creditors, the directors' plan to liquidate the company, and the impact of a court order against the company.
Where an auditor believes that a company's going concern is under threat and may not continue in the foreseeable future period, then the financial report should be prepared using the breakup basis.
Importance of the going concern basis
Basis for financial reporting
This principle serves as the basis of preparing financial statements. The statement of financial position shows what the entity will use to do business in the next financial year. When there is a threat to the company's existence, there will be no need to prepare such a statement.
Required by auditors
As mentioned above, external auditors are expected to understand the company's ability to exist for a long period of doubt. When there is doubt, then a different basis is used.
Enable the use of forecasting
One important aspect of the going concern concept is its use in forecasting. Budgets and financial models are prepared based on continued existence. Yes, it is only when management believes that the business will carry out operations in the coming years that it will forecast its future revenue and cash flows.
Build trust in companies
Shareholders will continue to hold their shares of the company because they trust that the business will remain for the long term. More so, investors invest in companies that they are sure will continue operations for as long as possible. Banks, creditors, and bondholders cannot provide loans, credits, and debts, respectively, to a company that they don't trust will remain in existence over a period of one year or the period of the loan or bond.
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