The Going Concern Concept - Research Paper Example

The Going Concern Concept Table of Contents Table of Contents 2 Background 3 Research objective 3 Research question 3 Research methodology 4 Literature Review 4 Findings and analysis 6 Advantages of going concern concept 6 Going concern uncertainties 8 Conclusion 8 Works Cited 10 Name of the student Name of the professor Course No. Date: The Going Concern Concept Background This research is aimed at analyzing the concept of going concern. According to the International Financial Reporting Standards (IFRS) standards, going concern is one of the fundamental assumptions based on which financial statements are made. This concept is based on the premise that a business entity will continue to operate for a considerable period of time in the future without getting liquidated. However, if a company is not a going concern, it means that it is facing bankruptcy. Once a company declares that it is not a going concern, immediately all its debts become due. The company will have to settle its dues by selling off all tangible assets. Intangible assets become worthless then (“The Going Concern Principle”). Research objective Going concerns are the only type of entities that can secure loans from banks and other institutions. Investors will only be interested to invest in a business that is expected to run for a long time in the future. A going concern is based on the idea that by continuing its operations in the business, a firm can yield the money that has been invested in the assets. In this way, profits will be generated and dues will be settled. It is important for a company to realize importance of the going concern concept in business and include this aspect in annual reports and statements (Hanif 3.3). Therefore, the objective of this research is to identify what a going concern is and ways in which an organization can effectively decide whether it is a going concern or not. Research question The research questions that have been selected for this analysis are: What is a going concern? How to ensure that a company is a going concern and will not go into bankruptcy? Research methodology The research is done on the basis of data provided by the International Financial Reporting Standards (IFRS) on the subject matter of going concern. Certain guidelines issued by the Generally Accepted Accounting Principles (GAAP) have also been referred to. Based on information collected, analysis was done with the help of books written by various authors as well as online resources. The analysis was designed in a manner so as to understand; the meaning of going concern; the different ways in which a firm can identify whether it is a going concern or not; the advantages of being a going concern; and the uncertainties that renders a firm as not a going concern. This research involves primary analysis of data based on qualitative method and rationale. Literature Review The research is done on the basis of guidelines laid down by IFRS and GAAP standards. The IFRS and GAAP standards are considered in order to ensure whether a company can be regarded as a going concern or not. It is necessary to study a company on the following parameters (“Going concern disclosure”): Adequate liquidity- In order to be able to continue the day-to-day operations, it is necessary for the firm to be able to generate adequate revenue so as to meet expenses that arise in the due course of its working. Unless these daily expenses are met, the firm will not be able to continue its operations. For instance, if there is a breakdown of machinery and immediate repair is required, the firm should be able to provide it so as keep the machine running and prevent stoppage of work. Similarly, organizational operations should be such that they can generate adequate revenue for the firm so as cover for its expenses. Otherwise, work may come to stand still, affecting its long-term survival. Remain in Business- A company might be affected from various external factors that influence its operations. For instance, existence of a strong competitor in the market or that of alternative products with better market positions and so on. These factors affect the company’s sales rate and consequently, its ability to yield profits. If the firm’s profits start to decline alarmingly, then there is very less possibility that it would stay in business as a going concern; unless urgent measures of reformation and development are taken. Similarly, governmental factors may also affect a firm’s life. If the government raises tax duties and other charges to a very high rate, then this might affect company’s extra reserves, rendering it as weak. (Robert 7). Cash flow analysis- This is required to analyze the trend of cash flows that the company has had in the past. If the trend is positive, then chances of the firm to remain a going concern would be quite high. Apart from this, it is also necessary that the cash flows reflect an increasing trend. In order to do this analysis, the cash flow statements of the last five to six years should be studied. Operational profit- This is the net profit that a company earns from its operations during a considerable period of time, which is generally one year. It is obtained by deducting the operational expenses such as, rent, electricity expenses and administrative expenses and so on, from the total operation profit that the firm earns from sales. If a firm is able to generate positive operational profits so as to be able to cover all its operational costs, then this would indicate that the company is functioning well and meeting all its expenses. It can also be deduced from this that the type of work that the company pursues and its work strategies are good enough to generate adequate revenue. Current Ratio- The current ratio is obtained by dividing the current assets by current liabilities. These current or short-term assets are required to pay off a company’s short-term or current liabilities. It is preferable that a company has a current ratio equal to or greater than 1. It indicates that the company has higher level of current assets compared to the level of liabilities. The current ratio of not only the current year, but also that of the last few years should be studied in order to understand whether the firm has had positive current ratios in the past or not. If not, then it would mean that the company’s performance has not been satisfactory, which in turn would raise questions regarding its survival (“Going concern”). Debt ratio- This ratio is ascertained by dividing the total debt by the total assets. This helps to measure a company’s leverage as well as to identify the proportion of assets that is financed by debt. If the debt ratio is greater than 1, then it would imply that proportion of debt is higher and as a result, the company has low solvency. Hence, the going concern aspect will be significantly affected. Net income to net sales- Having a high level of sales would not always mean that the company has high income or profits. For instance, if a firm has net sales of $200,000, then it shall be considered to have high revenue. Nonetheless, if its expenses are $210,000, then it would lead to a loss. Therefore, it is important that the firm earns such a level of sales revenue; this would enable the firm to not only be able to cover its expenses, but also generate adequate reserves and surplus (“How to Assess Going Concerns”). Growth and innovation- Considering the current market scenario, there is a high level of competition in almost all industry types. So, in order to be able to sustain in competition, it is important that a firm invests in research, development and growth measures. A firm needs to alter its strategies at regular intervals to keep pace with changing needs of the business. Financial experts comment that the only way for a company to be successful is by constantly changing itself according to needs of the market (“Going Concern Concept”). Skillful employees- It is important that the company possesses a team of skillful employees so as to be able to meet the challenges of work and deliver effectively. If employees do not work efficiently, it would be difficult for the firm to reach its operational goals and earn profits. Realistic targets- The firm’s objectives and goals should be realistic and decided upon the basis of industry conditions and capabilities of the company. Findings and analysis Advantages of going concern concept The reasons why firms need to follow the going concern concept are elaborated upon as follows (“The Going Concern Principle”): Obtaining credit and investments- As mentioned earlier, an investor always prefers to invest money in a firm that is expected to run for a long time. The reason for this is that investments made are entrapped in company’s assets whereby the firm generates revenue. The revenue is then utilized to provide investors with periodical returns. So, investors can earn such periodical returns only if the company functions properly and continues to operate in the same manner. Therefore, in order to obtain investments in the form of loans and other debts, it is important that the firm is able to prove its capability to earn sufficient profits to investors. It is necessary for a firm to acquire adequate credit so that it can purchase assets required for the business and meet other expenses. It is not possible to earn revenue from sales from day one of business operations. Hence, capital investment is necessary. Credit rating- A going concern company is expected to generate adequate profits in the future to ensure survival. Rating companies verify if a company can survive in the long run or not. Accordingly, firms are rated. Based on such ratings, investors and shareholders take decisions upon whether or not to invest. So, it is important for a firm to obtain a good rating. This is only possible if the firm is expected to survive in the long run. A bad rating report affects a firm’s ability to convince potential investors to invest. Employee satisfaction- Employees prefer to work in organizations that are expected to run for a long time so as to not lose their jobs. Without adequate job security, a firm cannot attract skilled and talented employees. Guaranteed salaries and wages- A going concern entity indicates that a firm is expected to earn sufficient revenue, thereby ensuring its survival. Hence, it provides guarantee to the employees, workers and other interest groups that they will be receiving their payments without any stoppages. Accounting implications- Financial statements are prepared on assumption that the firm is expected to continue its operations for a long period of time. Based on this assumption, financial statements include the aspect of discounting and forecasting. Such forecasting is done to analyze a firm’s profitability scenario in the future, such as, calculation of NPV, IRR and so on (“The importance of a going concern”). Full disclosure- In order to analyze whether or not a firm has the ability to function properly in the long run, it becomes essential to conduct an in-depth and thorough check of all components involved in business. This includes examining the firm’s financial position and strength, operational affectivity, strategies and plans and overall performance of the business from different viewpoints. Therefore, full disclosures of the company’s operation are facilitated (Kwok 27). Going concern uncertainties Going concern uncertainties refer to those issues, which impact a company’s long-term survival and hence, they cannot be called a going concern. Some of these uncertainties arise from (“What is a Going concern”): 1. Deteriorating level of liquidity, leading to massive short-term debts. 2. High financial risk arising out of high levels of debt. 3. Continuous losses for several financial years. 4. Lack of growth strategy due to weak financial position. 5. High level of short-term borrowings, which is not adequately supported with growth in business. 6. Inability of the firm to maintain liquidity ratios pertaining to lack of cash inflow. 7. Negative results of capital budgeting decisions. 8. Lack of innovative measures to develop new products and services in order to maintain survival in the market and combat high levels of competition. 9. Bankruptcy of a major debtor, leading to loss of revenue. When the abovementioned aspects are seen to exist in an organization, it becomes evident that the firm is most likely to get dissolved in the near future. Therefore, under such circumstances, a firm will not be called a going concern. Conclusion From the above analysis of the concept of going concern, it is evident that identifying the possibility of long-term survival of a company is necessary. Unless and until a firm can be called a going concern and its financial statements are prepared based on this aspect, it becomes almost impossible for the entity to gather investments or carry on with business activities. Therefore, it is essential for a firm to make sure that its performance reveals the fact that it can survive in the long run. Only then will it be called a going concern and can obtain the benefits of being so. From the above analysis, another major aspect that has surfaced is that survival of a company solely relies on one fundamental truth, which is delivering good and high quality performance. If performance of a firm is sound, it is sure to generate adequate revenue and the profits generated in turn help to meet all organizational needs, thereby guaranteeing its long-term survival. Works Cited “Going Concern Concept”. AccountingExplained. AccountingExplained.com, 2013. Web. 20 March 2014. “Going concern disclosure”. IFRS.org. IFRIC, 2009. Web. 20 March 2014. “Going concern”. Ready Ratios. Audit IT, 2014. Web. 20 March 2014. Hanif, Mohammed. Modern Accountancy. 2000. New Delhi: Tata McGraw-Hill. 2000. Print “How to Assess Going Concerns”. Dummies.biz. John Wiley and Sons, 2014. Web. 20 March 2014. Kwok, Benny. Accounting Irregularities in Financial Statements. Guildford: Gower Publishing Limited. 2005. Print. Robert, Anthony. Core Concepts of Accounting. 2010. New Jersey: Pearson Education. Print. “The Going Concern Principle”. Accounting Tools. Accounting Tools, 2014. Web. 20 March 2014 “The importance of a going concern”. BBC News. BBC, 2013. Web. 20 March 2014. “What is a Going concern”. Accounting-Simplified. Accounting-Simplified, 2013. Web. 20 March 2014. . Read More