07 Jun What is the Going Concern Assumption?
A company’s financial statements are prepared based on the going concern assumption. This implies that the company will continue to remain in business for the foreseeable future. External parties, especially lenders and suppliers, are willing to deal with a company because they assume that the company will remain in existence in the years ahead.
What does going concern assumption mean?
A company is said to be a going concern if it does not have the intention of liquidating its assets and closing down in the immediate future.
Why would a firm cease to be a going concern? The following circumstances may force it to close down:
⇨ If a company makes losses year after year, it may run out of funds to sustain operations. Lenders may not be willing to advance additional money if they think that repayment would not be made. In such a situation, the company could cease to be a going concern.
⇨ A company may be involved in an illegal business and government authorities may force it to close down. There could also be a situation where the court could order a firm to pay a large sum in compensation to a party that had filed a lawsuit. If the company does not have the resources to pay this amount, it could be forced into liquidation.
⇨ A firm may not be able to compete in the market if it fails to upgrade its products to keep up with its rivals. This could lead to declining sales and profits.
If the going concern assumption ceases to hold true for a company, its assets would be valued at the sum that they would fetch if they were sold. They would no longer be valued on the basis of their ability to produce the goods and services that the company provides.
Example of going concern assumption
Every company operates on the basis that it is a going concern. Here is a list of well-known firms that ceased to be going concerns:
Enron – the energy company based in Houston was involved in a massive fraud. Its managers inflated revenues and profits by fabricating accounting records. When they were caught, the scandal even caused Enron’s auditors, Arthur Anderson, to close down.
Pan Am – the iconic international airline declared bankruptcy due to its large losses. It was America’s largest airline until it collapsed in 1991.
Lehman Brothers – the investment banking firm was an industry leader until it closed down in September 2008, triggering the global financial crisis.
The going concern assumption is the premise on which a company’s financial statements are based. Every company that is a going concern operates on the basis that it will continue to remain in existence in the years ahead.