What is going concern assumption? The term “going concern assumption” refers to an accounting principle based on which a company’s financial statements are made. The American Institute of Certified Public Accountants (AICPA), which is the national professional organization of CPAs, describes this principle in the following manner:
Under the going concern basis of accounting, the financial statements are prepared on the assumption that the entity is a going concern and will continue its operations for a reasonable period of time.
What does that mean? In a nutshell, the definition is trying to convey that when a company’s income statement and its balance sheet are prepared, it is assumed that the business will remain in existence in the future.
When you read the meaning of the going concern assumption, the first question that comes to your mind could be, “why does that matter?” Would a company’s financial statements be any different if they were prepared with the assumption that the business would close down any day? Shouldn’t the financial statements be the same regardless of how long the company is going to be in existence?
The answer is an emphatic “no.” In this post, we’ll find out why. We’ll also understand the other implications of a company being classified as a going concern and why this is important.
The Going Concern Assumption
Practically all businesses operate under the going concern assumption. Why is this assumption important? One reason is that it provides confidence to anyone who deals with the company.
Let’s understand this with two examples:
Going Concern – Example 1
Consider a firm that approaches a financial institution for a small business loan. The borrower applies for an amount of $50,000 repayable over five years. The bank reviews the loan application carefully and is convinced that the company is a going concern. This means that the bank is reasonably sure that the business will continue to remain in existence in the years ahead.
This is a crucial piece of information for the bank. It would not be willing to lend to a firm that is not a going concern. In other words, if the bank thought that the borrower would close down in a year or two, why would it advance funds that are repayable over five years?
Going Concern- Example 2
Here’s another example that will help explain the going concern assumption. A small construction firm called Drake Brothers that began operations 15 years ago is facing financial difficulties. One of its biggest clients, a leading residential construction company, has closed down. Drake Brothers is unable to pay its creditors and files for Chapter 11 bankruptcy.
While the bankruptcy proceedings are in progress, Drake Brothers tries to raise a new loan. However, they find that it is impossible to find a lender that is willing to provide funds. That’s not surprising considering that the going concern assumption does not apply to the business. If the reorganization of the company’s affairs under the Chapter 11 proceedings is unsuccessful, Drake Brothers may have to close down.
There’s another thing you should know. The financial statements of a business are made on the basis that it is a going concern and will continue to exist in the years ahead. Consequently, assets are valued at their original cost, reduced by the depreciation that has been charged on them. If the company were not a going concern, the assets would have to be valued at the amount they would fetch if they were to be sold.
Additionally, certain expenses that would provide a benefit to a company in the next year could be classified as “prepaid expenses.” These expenses would be recognized in the subsequent year. If the company were not a going concern, it would be incorrect to defer the expenses to the next year.
Conditions of Going Concern
The going concern assumption is valid for a company that meets these conditions:
- It has sufficient funds: A company needs to have adequate cash to continue with its operations. Money is required in order to purchase raw materials, meet day-to-day expenses, and pay employees. A company should have the liquidity to meet these financial obligations if it is to be considered as a going concern.
- It is profitable: A firm should make profits if it is to meet the going concern assumption. This doesn’t mean that unprofitable companies aren’t going concerns. A firm could incur losses for a year or two or even more and then return to profitability. However, if it consistently makes losses, it is likely to start running short of cash. This could threaten its existence.
- It retains its critical assets: A manufacturing company relies on its machinery and equipment to produce the goods that it sells. These are crucial to its survival. If it sells all its machinery and uses the cash to pay its creditors, how will it continue with its manufacturing activity? The company must retain its assets, or at least the important ones if it is to meet the going concern assumption.
- It will remain in existence in the coming years: A business should function in a manner that indicates that it will still be there in the years ahead. In addition to sufficient cash, it should have paying customers (or the likelihood of getting these soon if it is a startup) and a product or service that is in demand.
Even a company that is profitable and has adequate liquidity could be in danger of being classified as one that is not a going concern. We’ll see how that could happen in the next section.
Red Flags Indicating a Business is Not a Going Concern
Here are some of the signs that indicate that a company may not be a going concern for much longer:
- Legal proceedings: If a company that manufactures only one product is accused of patent infringement by another firm, its existence could be in question. If it loses the legal battle, it may have to close down.
- A change in the law: A new law may declare that the product a company manufactures is illegal. This could jeopardize the firm’s existence.
- Loss of key customers: If a firm operates in the business-to-business (B2B) segment, it could depend on a handful of clients for survival. Losing a few big customers could reduce its sales drastically.
- Labor problems: A prolonged strike or repeated incidents of labor unrest could drain a firm’s cash resources and lead to its closure.
- Lack of insurance: A natural calamity could destroy a firm’s assets. If they aren’t adequately insured, it could result in a situation where the company is unable to restart operations.
Tips to Continue as a Going Concern
Here are five ways to ensure that your company remains a going concern:
- Maintain a cash cushion: You should keep enough money reserved to pay for six months of expenses. If you can manage more, that’s better. But don’t let yourself fall into a situation where you run out of funds. If this happens, you could have to delay payments to your employees and your creditors. That can do irreparable harm to your reputation.
- Buy the insurance policies you need: Insurance is possibly the only thing you pay for and hope you never have to use. Choose your insurance wisely. Paying a small insurance premium could save you thousands of dollars or more if you need to make a claim.
- Diversify your customer base: This point is especially relevant if you operate in the B2B segment. You don’t want to rely on only one or two clients for the bulk of your business. To diversify your customer base, we recommend you to learn some techniques to increase your market share.
- Keep an eye on the competition: You never know when a competitor could introduce a cheaper or better product. This could threaten your existence.
- Review your financial statements with your accountant: Don’t leave this task for the year-end. Review your accounting records every month or at least every quarter. This will give you time to take corrective action if you find something that you need to work on. Pay special attention to your cash flow forecast. This will help you to identify your future cash needs and give you time to arrange funds.
The Bottom Line
Although the phrase “going concern assumption” is primarily used by accountants, its meaning holds a high degree of relevance for others, too. Remember that as a company owner, you can’t risk your firm getting classified as a business that isn’t a going concern. If this happens, you could find it difficult to raise a loan or buy goods on credit.
It’s a good idea to review your cash requirements and ascertain if you would require funds soon. If you conclude that you may need a business loan, contact us for a quote today. At Camino Financial, our motto is “No business left behind.” Our team will work with you and do their best to provide you with the funds you need.
We’ll take care of the financing so that you can concentrate on running your business so it continues growing for years to come.