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.
- High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.
- Significant trading losses bieng 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.
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Which of the following may affect the going concern status of an entity?
High Gearing Ratio (Proportion of Long Term Debt to Equity).
Gearing ratio above industry norms makes the entity vulnerable to delays in repayment of loan installments and interest with the ultimate risk of liquidation.
Availability of short term running finance.
Availability of short term running finance may help an entity to overcome unanticipated cash flow shortage in the short term.
Successive trading losses.
Although in the short run, a loss making company may survive due to sound liquidity position, long term profitability is essential to maintain long term liquidity and hence the going concern status of the company.